Facoltà: Economia Cattedra: International Finance

TITOLO Hedge Fund Industry: Well and Alive?

RELATORE Prof.: Pierpaolo Benigno

CANDIDATO Giovanni Santella

Matr.: 609751 CORRELATORE Prof.: Mauro Micillo

ANNO ACCADEMICO 2008/2009

INDEX Foreword p. 3

Chapter 1 p. 8

1.1: Active versus Passive Asset Management p. 10

1.2: Risk Measurement and Risk Management p. 12

1.3: Leverage and short-sales p. 16

1.4: Liquidity p. 18

1.5: Beyond equity long-short strategy p. 20

1.6: Misconceptions p. 28

1.7: What are Funds of Hedge Funds? p. 29

1.8: Hedge fund due diligence p. 34

1.9: Hedge Fund Replication p. 37

Chapter 2 p. 41

2.1: Assets Under Management p. 41

2.2: 2008 Key Performance Facts p. 47

2.2.1: Individual Strategy Performance p. 52

2.3: 2009 Overall Performance p. 55

2.4: Performance of single strategies in 2009 p. 59

2.4.1: Convertible Arbitrage p. 59

2.4.2: Emerging Markets p. 61

2.4.3: Managed Futures p. 63

2.4.4: Fixed-Income Arbitrage p. 64

Chapter 3 p. 68

3.1: Regulation p. 68

3.1.1: The EU p. 71

3.1.2: The UK p. 73

3.1.3: The USA p. 74

3.2: Better Corporate Governance? p. 76

3.3: Risk Management? p. 78

3.4: Transparency and Due Diligence p. 80

3.5: Fees p. 82

3.6: Industry Consolidation p. 84

Chapter 4 p.

4.1: What Distressed Debt Strategy is about p.

4.2: Current opportunities p.

4.2.1: European distressed debt managers p.

4.2.2: North American distressed debt managers p.

4.3: Default rates p.

References p. 86

FOREWORD “Within five days Lehman had gone bust and it quickly became clear that the

world’s financial system had problems far beyond a single badly run investment

bank and temporarily frozen credit markets. After two decades of expansion and

deregulation, and the greatest bull market finance has ever known, many of the

world’s banks were dangerously undercapitalized. Governments were forced to

step in, providing capital, loans and guarantees to banks. In America, the euro

zone and Britain the sums involved so far amount to about one sixth of GDP.”1

After a severe economic drawdown, massive government bailout programs and

exceptional stimulus measures, central banks trying to stoke economy by

lowering interest rates, executives collecting million-dollar bonuses, irritated

investors with less confidence in the financial system, everyone is asking for

heavier regulation, enhanced transparency and more effective internal risk

management systems.

Without the assistance of governments and central banks, the economic distress

would have been extremely worse, but the recession has still been painful and,

more importantly it has prompted a sense of outrage at the financial industry.

Cases of firms like Lehman Brothers and AIG have pointed out that insolvency

issues related to a large player are relevant not only for the individual institutions

themselves, but also, and more importantly, for the stability and the integrity of

the entire financial and economic system.

Among the others, hedge fund industry was blamed for having played a crucial

role in the current financial and economic crisis. Managers were criticized as

being selfish and careless about the investors’ community. They were also

accused of having contributed to the selling pressure in the stock markets,

through short-selling transactions and particularly through the massive selling of

1 Unnatural selection, Economist.com, September 10th 2009.

shares to which they were forced because of deleveraging requirements and surge

in redemptions.

Other critics are addressed to the excessive use of leverage, to the fee structure,

to the lack of appropriate regulation and transparency about their strategies and

investments. Indeed, hedge funds are usually not required to file a registration,

nor to disclose data about performance, assets under management (AUM) and

their financial position. Managers are perceived as having the ability to move

markets in order to pursue their objective of enriching themselves and their

clients.

As a result, hedge funds have been accused of having magnified the financial

crisis due to counterparty concerns, loss of confidence by investors and increased

systemic risk. The Madoff episode has provided extensive evidence about the

drawbacks of loose regulation and offered support to those claiming a stronger

regulation and its enforcement in order to protect investors and the financial

system, by closing the gaps and eliminating the weaknesses of the hedge fund

industry. Although Madoff was not operating as a hedge fund, he operated

through several funds of hedge funds, so there has been a great reputational

damage and reduced investor confidence in the hedge fund industry.

Advocates of hedge funds, instead, claim that they have been able to obtain

historically higher returns, with respect to the conventional investment strategies.

According to them, each of these funds is a business and, occasionally,

businesses can fail and go bankrupt. Hedge fund failures are part of the financial

life, as well as bank or company failures. Of course, these failures do have the

potential to create dangerous effects on the financial markets, but investors

should always diversify idiosyncratic risk and hold portfolio of hedge funds as

opposed to just few hedge funds.

Hedge fund industry has changed a lot since it was born, in 1949. Modern hedge

funds offer several strategies and investment styles, thereby creating an

extremely heterogeneous industry.

In 1949 A.W. Jones set up the first equity hedge fund. Although it was not called

and created as a hedge fund, the portfolio was made up by long and short

positions in order to increase returns while reducing net market exposure, thus

the later definition of “hedged fund”. Jones used to short-sell stocks that were

overpriced relative to their fair value, he also made use of financial leverage to

further enhance performance by making large bets using limited resources. His

financial leverage was often around 1.5:1, composed of 110% long positions and

40% short positions. He also added a 20% performance, thereby becoming the

first money manager to combine leverage, short selling and alignment of interests

between agent and principal.

Jones also started to employ managers with stock-picking skills in order to

complement his own capabilities as a stock-picker and in 1954 he converted his

partnership into the first multi-manager hedge fund.

Jones’ fund was discovered only in 1996, in a famous article on Fortune written

by Carol Loomis: “The Jones no one keeps up with”. Jones had been able to

achieve risk-adjusted returns well above those of traditional funds during 1950’s

and 1960’s, even after the 20% incentive fee. Apparently, the fund was described

by Loomis not as a hedge fund but as a “hedged fund”.

The news about Jones’ fund performance created great excitement and by 1968

there were about 200 hedge funds in existence. Most of them perished because

they became too leveraged and were net long during the years prior to the market

downturns of 1969-1970 and 1973-1974, which surprised them. By 1971, there

were no more than 30 hedge funds in existence. This resulted in low competition

for investment opportunities and exploitable market inefficiencies. Hedge fund

industry recovered its popularity in the mid-1980’s and at the end of the decade

there were approximately 200 hedge funds.

Julian Robertson’s Jaguar fund, George Soros’ Quantum fund, Jack Nash from

Odyssey and Michael Steinhardt’s Steinhardt Partners were compounding at

40% levels. Not only were they outperforming in bull markets, but they

outperformed in bear markets as well. In 1990, for example, Quantum was up

30%, and Jaguar was up 20%, while the S&P 500 was down 3% and the MSCI

World Index was down 16%. The press began to write articles and profiles

drawing attention to these remarkable funds and their extraordinary

managers.”2

Until 1990, the great majority of hedge funds pursued either equity long/short

either macro strategies. Throughout the 1990s hedge fund industry has become

extremely heterogeneous. More strategies became available and correlation

between one fund and the other felt drastically, thereby giving the possibility to

funds of funds and other investors to combine risky hedge funds in order to build

conservative portfolios.

Since 1949, hedge fund industry has indeed attracted the attention of more and

more investors, but it has also raised many doubts within the community. The

implosion and the following government bailout of Long Term Capital

Management in 1998, the collapse of Tiger Funds in March of 2000 and of

Quantum Fund in April of 2000, after having experienced a decade of more than

30% annual returns, are some examples of high-profile incidents that have

overshadowed more than half a century of hedge fund history.

There is no question that hedge funds business model has been under pressure in

2008 and in the first part of 2009. These two years will result as a though period

for the hedge fund industry, with AUM likely to decline by 50% or 80% from the

once estimated $2 trillion. According to the Hedge Fund Research Centre of

Chicago, 12% of the total number of funds – approximately 7700 – has closed in

2008, corresponding to 10thousand job positions less within the industry. In 2 Ineichen A. and Silberstein K. (2008), AIMA’s Roadmap to Hedge Funds, November.

2009, Options Group Research Center estimates a further decline of job positions

of 20thousand – approximately 14% of the total.

The first section of this work introduces hedge funds. It provides a definition,

together with the description of the most important – and at the same time –

criticized characteristics of these investment vehicles. It also provides an outline

of the hedge funds' investment strategies. Finally, it addresses the topics related

to funds of hedge funds (FoFs) and the brand new hedge fund replication

strategy.

The second section aims to analyze the performance of the hedge fund industry

during 2008 and the first part of 2009. The returns of the overall industry and of

individual strategies are compared with the major indexes. In particular, major

trends in financial marketplaces are outlined and their consequences on broad

equity, bond, commodity and hedge fund indices are analyzed.

The third chapter deals with the changes that the hedge fund industry will likely

face in the near future. Namely, a more rigorous regulation, more stringent

transparency and disclosure requirements and lastly a more effective risk

management process. Managers have to adapt really soon to this “new world”

and keep up-to-date with the upcoming new legislation or they risk to be

unprepared.

The last part of this work is dedicated to the opportunities related to distressed

debt strategy. As the economic and financial environment and credit market

conditions have worsened during last year, many companies are facing

difficulties, both at the financial and operational level. Even though the recent

tightening of liquidity and the volatility in equity markets may represent a bad

scenario for some investors, others are positioning themselves and wait to

capture a whole range of distressed debt opportunities.

CHAPTER 1 1.1: Active versus Passive Asset Management; 1.2: Risk Measurement and Risk Management; 1.3:

Leverage and short-sales; 1.4: Liquidity; 1.5: Beyond equity long-short strategy; 1.6: Misconceptions;

1.7: What are Funds of Hedge Funds?; 1.8: Hedge fund due diligence; 1.9: Hedge Fund Replication;

Despite the fact that hedge funds are currently in the spotlight and that they are

drawing several critics, surprisingly very little is understood about who they are

and what they do. It is indeed not easy to define what a hedge fund is.

The fund is a collective investment scheme, or better a pooled investment

vehicle, meaning that investors entrust their money to a fund manager, who then

invest in publicly traded securities in an effort to make a positive return.

Hedge funds are also defined as loosely regulated investment vehicles because

they are not subject to any formal constraint about use of financial leverage, short

selling, types of securities the fund can invest in and investment strategies. In

other words, they fall outside many of the rules and regulations governing mutual

funds. In addition, hedge funds are generally not required to issue periodic

reports about their position. It goes without saying that even though the term

“hedge fund” seems to imply market neutral positions and low risk strategies,

their actual risk profile is quite different.

Hedge funds are still subject to the prohibitions against fraud, and their managers

have the same fiduciary responsibilities as other registered investment advisers.

Exemption from regulatory and investment restrictions, which are typical for

other investment vehicles comes at the cost of restrictions on public advertising

and solicitation of investors. In fact, hedge funds cannot solicit or advertise to

general audience. Put differently, by limiting the number of investors, by

imposing minimum investment levels and requiring that investors are accredited,

which means they meet an income or net worth standard, hedge funds have been

able – probably will not be able anymore in the next future – to bypass

registration requirements3.

Lack of constraints, which in turn means lack of transparency, allows skilled

managers to achieve higher returns relative to more regulated investment

vehicles. In particular, hedge funds try to profit in all kinds of markets by

pursuing leveraging and other speculative investment practices.

Scarce transparency is another important characteristic which, as we said earlier,

is strictly linked to the loose regulation and implies high difficulty in obtaining

reliable information. Historically, hedge funds have tried not to reveal their

position, strategy, performance and the value of assets under management. There

are two reasons that incentive hedge funds to not disclose such data: the first one

is to protect what managers believe to be valuable, or better to defend their

competitive advantage or what they do better than the market. The second reason

is related to the fact that once the market knows a hedge fund position it can start

trading against it.

Hedge fund managers ask investors to pay two different fees. First, they ask a

fixed reward for their managing skills, which consists in a periodical asset-based

fee that usually range between 1%-2% of the assets under management. Then

they charge a performance-related fee of about 20% of the realized profits. It is

common for such fee to be effectively paid only only on new profits, not on

profits recovering from previous losses. This mechanism, known as high-water

mark, implies that managers do not receive any performance fee if they incur in a

loss, until the loss has been made up, that is when AUM level reaches and goes

beyond the previous highest level.

The performance fee can be considered as a call option: managers pay a premium

which is fixed and known in advance, putting some of their wealth in the fund.

They then have the right to participate in the unlimited upside. The premium

serves to align interest and avoid conflict of interests between agent and

3 In Italy Hedge Funds and Funds of Hedge Funds are subject to Bank of Italy and Consob rules. In the USA, hedge funds are not required to register with the SEC.

principal. If a manager has nothing of his net wealth invested in his funds, this

option is actually like a call option granted to the manager for free. In this

particular case, the manager has a zero initial cost and nothing to lose. He will

obtain cash flows that are positive, never worse than the management fee and

characterized by an unlimited upside. This means that manager’s interests are not

properly aligned with those of the investors.

The main purpose of the performance fee is to provide incentives to the fund’s

managers to generate positive absolute returns as managers have a claim on a

share of the profits, whereas the high watermark serves as an incentive to avoid

losses. However, the high watermark has a negative side effect as it also

incentive managers to close the fund after a large loss, raise new financial

resources and re-open a new fund with a new high watermark, so that they will

be able to obtain 20% performance fee soon again.

Hurdle rates are often used as well, implying that a performance-related fee is not

paid below a certain return level, quite often the risk-free rate of return. They

establish a floor that managers have to exceed in order to obtain the performance

fee, thereby providing an incentive to perform well.

1.1 Active versus Passive Asset Management

One of the reasons of the increasing popularity of hedge funds over time is the

belief that hedge fund managers are better able to produce positive alpha, i.e.

superior returns over the expected return, than traditional investment vehicles,

such as mutual funds.

Hedge funds are “active products”, also defined as “pure skill asset class”. This

means that their results depend directly on the capabilities and skills of the

managers. Hence, when investing in a hedge fund manager who is free to pursue

absolute return strategies, one is automatically investing in the manager’s skills

and not in an asset class. Hedge fund managers actively manage their portfolio,

seeking absolute returns while protecting the principal from potential losses.

They do not have to follow or track any benchmark, nor have to respect any

constraint. This approach implies a constant assessment of risk and a continuous

adaption of the portfolio to changes. Personal judgment is also fundamental for

active managers.

On the other side, funds seeking relative returns, e.g. mutual funds, compare their

performance to an index or benchmark. These managers usually construct their

portfolio by following the index and then applying their picking skills in order to

increase the weight of appealing securities and under-weigh less favored

securities.

The difference between the two is that active managers always try to obtain

positive compounding of the principal, i.e., to make money every year, while

controlling potential financial losses and avoiding negative compounding of

AUM. Passive managers, on the other side, pursue relative returns. They are still

happy if they succeed in performing better than the benchmark, even if it means

to have a lower negative return.

The two approaches diverge in bear markets, when active managers do not

follow the benchmark, but try to achieve positive results.

Chart 1.1: Active versus Passive Asset Management (AM)

Source: AIMA’s Roadmap to Hedge Funds – November 2008

More precisely, among the different forms of passive management indexing is

the most passive. This technique consists in tracking the index, with zero degree

of freedom and no tolerance for performance variations. Then comes

benchmarking – the traditional form of active AM – where the manager has got

some discretion in over or under-weighting some securities with respect to the

benchmark, in order to beat it. In this case the risk-adjusted performance of the

manager is expressed in terms of Information Ratio (IR), which is the excess

performance, over the benchmark, divided by the risk taken, i.e., the standard

deviation of the extra-returns.

At the other extreme there are private equity funds and entrepreneurs. An

entrepreneur can be considered as an investor, making a specific and focused

investment. It is purely active management, highly based on personal skills.

The distinction between active and passive asset management is probably not as

clear in practice as it is in theory, or better it is likely to become less clear in the

future: on one side, hedge funds try to become more transparent and more

process driven in order to attract more investors. This leads to a form of self-

constraint. Reasonably, there will be also provisions in the near future to enhance

it. On the other side, passive managers are trying to loosen up their constraints to

add more value.

1.2 Risk Measurement and Risk Management

Absolute and relative-return managers also differ in the way they define risk and

subsequently manage it. In a relative return context, risk is defined as tracking

error, i.e., the standard deviation of extra-returns over or below the benchmark.

Tracking error is generally considered as the dispersion around the average value

of the fund’s extra-returns compared to the benchmark. In other words, it

measures how volatile the manager is in delivering extra-performance.

In the absolute return world, managers look at the total risk. They perceive risk

as compounding capital at low or negative rates over extended periods of time, so

they do care about downside protection. This means that when analyzing hedge

funds performance, several alternatives to traditional risk measures, such as

volatility or Sharpe ratio, are generally used. For example, downside volatility

measures the volatility of the returns falling below the investors’ minimum

acceptable level. Value-at-Risk (VaR) quantifies the amount of the portfolio

value that can decrease, with a stated probability, over the period of reference.

VaR typically states the maximum amount by which the portfolio can decrease,

using 90%, 95% and 99% confidence levels.

When speaking of hedge funds, it is often said that their returns are characterized

by fat tails, meaning that observations in the right and left tails of the return

distribution have a higher probability relative to what the normal distribution

predicts. The term fat tails refers to distribution moment called kurtosis, or better

excess kurtosis over the level of 3 of a normal distribution. Higher kurtosis

means that the distribution has a more acute peak around the mean compared

with the normal distribution and fatter tails. Usually, investors are more

concerned with the left fat tail of the distribution i.e., large negative returns

having an higher probability to occur, and since they view a greater chance of

extremely large deviations from the expected return, that is fatter tails, they

perceive the investment as being riskier.

In addition to excess kurtosis, investors also look at the skewness, which

represents a departure from the normal distribution as well. In particular, they

care about negative skewness: higher probability of returns above the mean, i.e.

small gains, but a few extreme losses. Put differently, negative skewness implies

long left tails, because there is a limited, though frequent, upside compared with

a somewhat unlimited, but less frequent downside.

Even though fat and/or long tails are not a distinguishing feature of hedge fund

returns versus other investments, hedge fund managers have to properly take into

account the possibility of experiencing such return observations. Since the VaR

figure does not tell managers what will happen in the remaining 10%, 5% or 1%

probability and since investors are concerned with large negative returns,

managers usually complement their risk measurement process with stress and

scenario analysis.

Another measure of risk which is used to capture the skewness and excess

kurtosis of portfolio returns distribution is the expected shortfall (ES). It

measures the expected return of the portfolio in the worst 1%, 5% or 10% of the

cases, so it is used to capture the expected loss distribution in the tail of the

distribution. In other words, ES is a measure of risk in the sense that it estimates

the value of the portfolio focusing on the worst losses or at least ignoring the

most profitable but unlikely outcomes.

Measuring risk is not sufficient. After measuring, it is important to effectively

manage risk. Risk measurement is quite objective and quantitative as it is usually

based on historical financial data, which are assumed to hold true for the future.

On the other side, risk management is more subjective and qualitative.

Experience, skill, open-mindedness for and toward change are required.

Additionally, more than managing risk managers should be able to manage

uncertainty. By definition risk is indeed related to situations in which a

probability distribution of outcomes is known or at least can be calculated, while

uncertainty describes situations in which probabilities are unknown. So risk

management deals with adapting the fund’s portfolio to the changing

environment.

It is clear from the definition of risk that capital preservation is not part of the

mandate of a relative-return manager, because in both indexing and

benchmarking the return objective and the risk are defined relative to a

benchmark. Hedge funds, on the other side, do not track any parameter. They

seek absolute returns by exploiting investment opportunities and avoiding losses,

hence the term total risk. In other words, active risk management is the process

that balances the investment opportunities with the probability of capital

depreciation. This means that under the absolute-return approach there is

consideration for the upside and for the downside as well and even though

correlation increases among all investment types during falling markets, hedge

funds manage to offer investors the reassurance of downside protection.

Moreover, managing derivatives, leverage, short-selling requires experience and

skills different from those required for managing money while pursuing relative

returns. In fact, when facing a contraction of credit, liquidity or an exogenous

shock an over-leveraged manager might face huge losses while a manager who

has managed his fund effectively and have well-secured resources available has a

great opportunity for investment.

Chart 1.2: Relative versus Active-return

Source: AIMA’s Roadmap to Hedge Funds – November 2008 – adapted from Ineichen (2001)

As mentioned earlier, absolute return managers seek to compound capital. When

compounding capital is a major objective, avoiding losses and short-term

downside volatility is fundamental. To have an idea, a 10-year investment of

$100 (A) that starts compounding at 8% from the second year will end at $200. A

10-year investment of $100 (C) that compounds at 8% for the first nine years and

then falls by 50% will end at $100, as well as a 10-year investment of $100 (B)

that falls by 50% in the first year and then starts compounding at 8%.

It is always better to have a good constant compounding rate than having

excellent years and short-term, horrible losses that ruin the overall compounding

rate. Active managers not only prefer more return over less but, unlike a relative

return manager, do care about capital preservation because they assign to capital

depreciation a disutility larger than utility related to capital appreciation.

Chart 1.3: The effects of negative compounding

Source: AIMA’s Roadmap to Hedge Funds – November 2008

Finally, the definition of risk has important consequences on the evaluation of the

fund’s position. For a relative-return manager, moving to a cash position is

perceived as deviating from the benchmark. Hence risk increases since the

probability of underperforming increases. For a hedge fund cash represents the

risk-neutral position. Shifting to cash means reducing risk, because it allows

reducing the probability of negative compounding and losses.

1.3 Leverage and short-sales

« Leverage is borrowing money to amplify the outcome of a deal… It [leverage]

turns good deals into great deals”4 allowing growing tremendously rich. Using

leverage affords the levered entity to obtain higher returns, but increases also

risk, since it works both on the up-side and down-side, amplifying potential gains

as well as potential losses. In other words, leverage undoubtedly has its

advantages, but they come at a price. If a hedge fund is too much leveraged and

the market moves in the direction opposite of the manager’s opinion, it ends up

losing too much money.

4 Jonathan Jarvis (2008), The crisis of credit visualized

“…well-deployed financial leverage can greatly enhance performance. Nearly

every corporation and every homeowner uses it in forms of loans, mortgages and

so on. However, excessive leverage can be ruinous. This is true for corporations

and homeowners as well as hedge funds”5 …and banks.

The objective of using leverage is to exploit new investment opportunities

without having to take off other positions prematurely, or to magnify

opportunities lying in small price discrepancies. However, the benefits have to be

superior to the cost of borrowing money.

We cannot say that leverage per se is good or bad, since it should be evaluated

together with market exposure, credit risk and illiquidity. Having a leverage of

4:1 instead of 2:1, i.e. assets of $100 funded by equity of $25 or $50, does not

automatically imply that there is a higher risk. The leveraged entity could have

invested in government bonds while the less leveraged entity could have invested

in stocks.

Of course, use of leverage has to be balanced with opportunity set, strategies and

current financial system conditions. For example, if the market environment is

stressed, credit is contracting and there is an increasing illiquidity it would be

better not to allocate many resources to strategies that are highly levered, such as

fixed income arbitrage.

Differently from mutual funds, who can only go long and decide not to invest in

a particular company or sector if they don’t like it, hedge funds do more: they

can short-sell. Thanks to short positions, hedge funds are able, at least in

principle, to achieve consistent returns in bull as well as bear markets. In other

words, to them it makes no difference whether the market is going up or down.

Unlike long positions, short positions are taken in overvalued stocks, i.e. those

securities the manager expects to decrease in value because their price is too high

relative to the fundamentals of the underlying companies. In order to short sell,

the manager first identifies stocks whose price is likely to decline, borrows them

from a prime broker and immediately sells them at the current price. The 5 Ineichen, A. (2006), Q&A on Leverage, Alternative Investment Solutions, August.

manager later closes the position by purchasing these securities, ideally at a

lower price than he sold them for, and returns them to the broker. By this way,

the manager realizes a profit even in a bear market outlook.

The history of hedge fund failures shows us that it would be wise to structure the

leverage position in order to withstand unexpected and unprecedented market

movements. In such cases hedge funds are usually forced to exit their

investments at inappropriate times in order to meet their debt service, because it

is rarely the case that they have allocated some resources in cash.

The lesson is to monitor leverage structure and investment positions because

short-term fluctuations, illiquidity or contraction of credit could be fatal. It is also

important to recognise that as some point in time it is inevitable to fail in

predicting the future. Instead of leveraging the entire investment portfolio there

should be some cash reserve or at least some available credit line.

1.4 Liquidity

Hedge funds are not liquid products. They usually have lock-up periods, during

which investors must commit their money, extending for months or years.

Certain hedge funds suspend or defer redemptions as a defensive measure

because they want to avoid unprofitable liquidations of their positions. Not only

they limit the possibilities to effectively redeem the investment but they can also

require redemption notices.

Hedge funds also use gates, thus limiting the amount of withdrawals from the

fund during a redemption period and the amounts of money that can be

withdrawn on a particular redemption date. It goes without saying that investors,

both funds of hedge funds and direct investors, perceive such an investment as a

medium/long-term investment.

The reason behind lock-up clauses and gates is that hedge funds need to align

financial resources to their financial needs. Some absolute return strategies are

long-term by nature and long-term resources are necessary in order to profit from

them.

Investing in distressed companies, for instance, is a long-term and illiquid

strategy. Acquiring distressed debt and going through the bankruptcy proceeding

is a long task and the outcome is rather unpredictable. Thus, a long-term

commitment from the fund’s investors is required. By this way the fund

managers make sure that liquidity issues, i.e., a mass exodus of capital during

periods of troubles, will not force them to sell at inappropriate times. In other

words, if the fund’s capital base is not secure and stable there is a chance that

capital might be withdrawn at times when it is most needed.

Managers with a sound capital base available, are able to exploit potential

opportunities, especially in a stressful market environment where everyone

panics and overreacts to bad news.

Hedge funds accept and pursue illiquid strategies because they try to achieve

high risk-adjusted returns. They do take risks because they expect a reward for

providing liquidity to the market. They buy less liquid securities at discount,

while going short on liquid and overpriced securities, because they expect to pick

up a liquidity premium. However, such a strategy does not work under periods of

financial stress, when investors fly to quality, switching from lower quality and

less liquid securities to higher quality assets. In this situation, hedge funds can

incur in huge losses.

Ivan Guidotti, of Olympia Capital Management, shows that that there is no

significant relationship between lock-ups and alphas, except for event driven

strategies. However, we pointed out that event driven strategies, of which

investments in distressed debt are part, are the most illiquid and thus require

long-term resources in order to profit. We can say that lock-ups and redemption

notices are positively related to alpha, especially for less liquid strategies. This

implies that investors that seek to invest in higher liquidity funds might pay the

price of reduced alphas.

The positive relationship between liquidity terms and positive alphas indicates

that illiquidity premiums do exist and that more successful hedge fund managers

are probably more effective in imposing harder liquidity terms.

Guidotti also shows that young hedge funds tend to outperform older ones and

that the best young funds are the most illiquid ones.

Not only it is quite difficult to cash out an investment in a hedge fund “at will”, it

is also rather difficult to enter a hedge fund. Successful hedge funds tend to

close, sooner rather than later, their funds to new investors. Being too big could

become a problem, especially if the fund is exploiting arbitrage or quasi-arbitrage

opportunities.

Liquidity represents an extremely important issue also because of the

consequences it has on funds’ valuation process. Since a larger number of hedge

funds invest in thinly traded and illiquid securities it becomes more difficult to

calculate in a proper way the fund’s month-end net assets value. This problem is

compounded when market volatility increase or when credit markets become

illiquid and thinly traded as in 2008.

1.5 Beyond equity long-short strategy

The first hedge fund was a long-short equity fund and was rightly described as a

hedged fund. Nowadays, the term “hedge fund” refers to an extremely

heterogeneous asset class, extending from the original low risk, market neutral

strategy of Jones, which have low correlation to the overall market movements to

include directional, unhedged and highly leveraged strategies.

Intuitively, hedge funds provide diversification strategies. Since they invest in

several types of strategies and employ several investment techniques, they show

returns that tend to be uncorrelated with stock market indexes and other

traditional investments. Hence, they can be used to improved investors’ risk-

adjusted returns.

The traditional classification proposed by Tremont advisers identifies four main

categories: Relative Value, Equity Long-Short, Event Driven and Tactical

allocation. Each of these categories is characterized by different risk-return

profiles and includes different sub-strategies. Additionally, each manager has got

his own investment style and can interpret strategies in a personal manner,

different from others. A further factor to be considered is that managers tend to

employ multiple strategies, in order to achieve a more stable stream of returns

over different market cycles. They often drift away from their area of expertise,

so to seek opportunities in related investment areas.

1. Managers following an Event Driven approach try to indentify particular

events that have the potential to influence the asset valuation. They take

advantage of announcements and other one-time events.

► Distressed Debt: investing in distressed companies means investing across the

capital structure – debt and not equity – of companies subject to financial or

operational difficulties. Such companies might currently be in a bankruptcy

proceeding or appear to likely declare bankruptcy in the near future. Hedge funds

start accumulating near-default or defaulted bonds at deep discount to intrinsic

value, due to difficulties in assessing their proper value, lack of research

coverage, or inability of traditional investors to continue holding them. Then,

they resell them later for a profit, when the restructuring proceeding has driven

the price upward. Moreover, in a worst-case scenario, the manager could realize

a profit if the company is liquidated, provided that the manager had bought

senior debt in the company for less than its liquidation value.

Additionally, some managers have developed specific competences in

restructuring and bankruptcy proceedings, hence they invest in distressed debt in

order to go through the entire restructuring process, in the belief that the

company will successfully reorganize and return to profitability. When upon

emergence from bankruptcy bondholders’ claims are turned into the new

company’s equity, they acquire a long-term control over the new company.

The ideal situation is the one in which the distressed company has financial only

and not operational problems because the manager typically can rely on the

operational stability to increase the probability of success of the bankruptcy

process.

► Special Situations: such managers typically invest both long and short, in

stocks and/or bonds expected to change in price due to unusual events that occur

during the lifecycle of a company. Spinoffs, stock buybacks, financial

restructuring and recapitalization are all events considered to have an effect on

the company’s securities. However, managers need to have a certain degree of

flexibility in order to pursue event investing across different asset classes and

take advantage of shifts in economic cycles. They usually hold directional

positions and do not hedge in a combination of event driven equities and credit.

Returns are obtained when the event takes place.

► Risk Arbitrage or Merger Arbitrage: Funds bet on merge transactions involving

public companies. In particular, by short-selling the buyer and going long the

target company, they bet on their view that the acquisition will go ahead and that

the deal will close successfully. In other words, they believe that the spread

between the transaction bid and the lower target trading price will narrow as the

deal gradually closes and prices will converge. Typically, the bid price is higher

than the trading price to take into account synergies and eventual other premiums

paid by the would-be acquirer. The principal risk is deal risk: should the deal fail

to close, the buyer’s stock price goes up and the target’s stock down.

If, for example, the market believes there is a 60% probability that the deal will

close but the fund managers perceive that the probability of success is closer to

80%, the trader will take a position to exploit the difference. He will take the

opposite position if he perceives that the probability of success is lower.

2. Managers pursuing Relative Value strategies tend to identify normal

relationships between different securities and they try to profit from

significant deviations from this long term relationships. This approach usually

implies a neutral net market exposure, although leverage is used to enhance

returns.

► Convertible Arbitrage: it involves investing in corporate debt that is

convertible into stocks and simultaneously short-selling the corresponding stock,

trying to find an arbitrage between the value of the two different types of

securities issued by the same company and exploiting the pricing error made in

the conversion factor of the security.

Managers typically build long positions of convertible and other equity hybrid

securities and then hedge the equity component of the long securities positions

by shorting the underlying stock. By this way, they make the position less

sensitive to the stock price’s fluctuations. In other words, they try to exploit

inefficiencies related to a specific company in the market while offsetting long

with short positions, thereby reducing market-level risk.

Thanks to this strategy, managers are able to achieve different sources of return:

initially they are rewarded from the short sale of the stock, then by the income

stream of coupons from the convertible instrument.

When the underlying share price is above the strike price, the bond is in-the-

money, which results in an appreciation on the bond’s value. When the

underlying share price is below the strike price the bond is out-of-the-money.

When the bond is deeply out-of-the-money it trades in a similar way to straight

bonds. To be noted that instruments with embedded options are more sensitive to

upward movements of the underlying equity and less sensitive to downward

movements. So the idea is to make money from the bond if the stock price goes

up and make money from the short sale if the stock price goes down.

Managers can be effective in capturing this price sensitivity discrepancy.

Moreover, the price of an equity-linked instrument, such as a convertible bond,

takes into account the market's expectation of the volatility of the stock over the

remaining life of the investment, because of the embedded option on equity. If

the perception of this volatility increases, the price of the instrument will

increase.

► Fixed Income Arbitrage: hedge funds take advantage of inefficiencies and

pricing disparities between related fixed income instruments, caused by changes

in investor preferences or by fixed income market fluctuations. For example, they

take opposite positions in instruments like coupon bearing treasury bonds and

zero coupon bonds, or bonds having different credit qualities. In order to exploit

interest rate-related opportunities, they assume opposing positions in fixed

income securities and their derivatives. Because the valuation disparities between

related instruments are small, managers usually employ leverage to enhance their

overall returns.

Interestingly, hedge funds following this approach usually take position in

mortgage-backed securities.

► Equity Market Neutral: such funds take long and short positions of similar size

in stocks, thus minimizing exposure to the systematic risk of the market and

insulating performance from market volatility. Long positions are taken in

securities expected to rise in value while short positions are taken in securities

expected to fall in value. The main objective is to exploit investment

opportunities related to specific, individual stocks, while maintaining a neutral

exposure to broad groups of stocks such as sector, industry, market

capitalization, country, or region. The securities may be identified on various

bases, such as the underlying company's fundamental value, or with a

macroeconomic top-down approach, or a technical analysis on the pattern of

price movement.

3. Equity Long/Short is the original and probably the most basic hedge fund

investing approach. It involves setting up equity investments with a

directional bias, differently form equity market neutral approach. Managers

go long in anticipation of rising prices and they go short when they expect

declining prices, i.e. when they perceive the stock is overvalued.

► Growth Stocks: the manager invests in companies experiencing or expected to

experience a strong growth in earnings per share. Growth stocks are usually those

of small or mid-capitalization companies and almost always technology

companies. A growth stock usually does not pay dividends, as the company

prefers to keep on reinvesting retained earnings.

► Value Stocks: it involves buying a stock that is perceived to be underpriced

relative to the intrinsic value of the underlying business, i.e. the stock price is low

given company fundamentals such as high earnings per share, good cash flow,

strong management, etc. Common characteristics of such stocks include a high

dividend yield, low price-to-book ratio and/or low price-to-earnings ratio.

Possible reasons that a stock may sell at a perceived discount could be that the

company is not appreciated by investors and not correctly judged by the analysts.

The manager takes short positions in stocks he believes are overvalued, i.e. the

stock price is too high given the level of the company's fundamentals.

► Dedicated Short Bias: managers tend to maintain net short exposures in

equities. In other words, they earn returns by taking more short positions than

long positions. The strategy is based on detailed individual company research

and risk management in order to identify companies with weak cash flow

generation while offsetting these short positions with other long positions.

4. Tactical or Directional strategies

► Global Macro: managers typically construct their portfolios employing a top-

down global approach in order to forecast how political trends, government

policies and global macroeconomic events will impact on financial markets.

They consider factors such as interest rates, economic growth, inflation, etc. and

rather than looking at individual corporate securities, they seek to profit from

changes in the value of entire asset classes, participating in all major markets –

equities, bonds, currencies, commodities, interest rates – even if not at the same

time. For example, the manager may hold long positions in the Euro and U.S.

equity indices while shorting the Japanese Yen and U.S. treasury bills.

Profits are made by correctly forecasting and systematically anticipating price

movements, having the flexibility of a broad investment mandate. Hence, the

ability to enter into practically any market using any instrument.

► Managed Futures: futures managers aim to be profitable in any economic

situation, in bull as well as bear markets. They usually do not have a particular

preference about being net long or net short and they also invest globally, trading

in a large number of independent sectors and financial markets.

Managers tend to largely rely upon historical price data and market trends.

Strategies are built to exploit price trends regardless of direction. Once a trend in

futures markets is identified, managers invest in the same direction of the trend,

by either buying long or selling short, in the attempt to capture it. They hold the

position for as long as the trend is intact and favorable thus realizing as much

gain from it. Then they exit the trend by closing positions as soon as possible.

Given the nature of the investment strategy, managers prosper in periods of

extreme directional bias and turmoil. However, they must commit their resources

to the long term as price trends could take some time to develop.

Futures are flexible financial instruments that can be used to profit from both

rising and falling markets. Managed Futures managers utilize such instruments to

make speculative investments in agricultural commodities such as corn or cotton,

in crude oil, gold and other commodities. They also invest in financial markets,

in stock indexes, currencies and interest rates.

They take directional positions on certain economic or company specific events,

employing a significant amount of leverage as the strategy involves the use of

futures contracts.

Future contracts also offer some advantages: first of all they are traded on global

exchanges which provide publicly accessible quoted bid and offer prices. Hence,

gain or losses on outstanding positions and their current value can be easily

determined. It goes without saying that this strategy differs from other strategies

that typically involve investments in over-the-counter (OTC) derivatives which

are not traded on a centralized exchange.

As a consequence, market values of such instruments are not readily available

and managers can experience troubles in making valuations and then manage

risk. On the other side, futures do not create problems for valuation because there

is clear price transparency.

It has to be noted, however, that some hedge funds that engage in managed

futures strategies employ also other strategies. Hence futures represent only a

component of a synthesis of instruments.

Futures contracts are also liquid instruments, meaning that positions can be easily

entered and exited. This feature is particularly important when managers want to

reduce or eliminate an outstanding positions as they notice that a trend is

reversing, thus avoiding large drawdowns and significant losses for their

investors.

Collectively, managed futures strategy has a relatively low correlation to many

other hedge fund strategies. It is also characterized by low to negative correlation

to equities, especially in periods of poor performance.

5. Specialty strategies

► Emerging Markets: they invest in currency, debt and equities and of countries

with emerging markets, such as China, India, Latin America, Southeast Asia, part

of Eastern Europe and parts of Africa. These countries are considered to be in a

developing or less mature phase. More precisely, they are in are in a transitional

phase, between developing and developed status.

Emerging markets managers face specific issue when designing their strategies

because these markets are usually characterized by higher GDP growth as well as

higher volatility and inflation levels.

Moreover, managers hedge such investments by taking various positions in

developed markets.

1.6 Misconceptions

Hedge funds are usually considered as being speculative funds or gamblers. They

indeed take risks in order to seek absolute returns, since there would be no excess

return if all risk was hedged. However, their key objective is to realize stable and

consistent positive returns with low probability of financial losses, i.e., while

protecting the principal against negative compounding. In order to do that, they

usually hedge and they are exposed to risk just when they expect a reward from

bearing that risk.

Hedge funds also use speculative instruments together with short-sales in order to

exploit investment opportunities and that leads many people to wrong

conclusions. It is not said that using such instruments or techniques increase risk,

actually the opposite effect can be obtained when speculative instruments are

used to offset other positions. Ironically, many hedge funds and their investors

firmly believe that conventional “long-only” investment strategies are extremely

speculative since they are fully exposed to the fluctuations of the market, no

matter how much the idiosyncratic risk could have been diversified away. To

them, being fully exposed irrespective of the business cycle, market volatility and

opportunity set is not the right way to manage money.

Hedge funds are often blamed for increasing systematic risk of financial markets

and even recently they have been object of several critics. They indeed make use

of leverage to improve their returns but what is dangerous for the leveraged

entity and for financial markets is not leverage itself but the excessive use of

leverage. If this is the case, and a market or liquidity shock occurs then, the risks

hedge funds assumed are directly transferred to the trading counterparty or to

creditors. There is also an indirect effect on financial markets and their

participants: the disappearance of a player willing to bear risk can cause price

changes and thus increase price volatility. Both the direct and indirect effects can

cause a contraction of credit and liquidity, leading to severe consequences for the

real economy.

There is no question hedge funds have the potential to destabilise financial

markets if they are too much levered. However, they can also contribute to the

stabilization of financial markets and can improve their efficiency through

providing liquidity, investing in less liquid securities and by bearing risks that no

one else would be willing to bear. For instance, when equity markets were going

down, in summer 2002, hedge funds emerged and provided liquidity to the

market.

Also, looking at what happened in September 2008, it is clear that excessive

leverage – but not leverage itself – is dangerous, independently from the legal

status of the financial market player.

1.7: What are funds of hedge funds? “A fund of hedge funds is an investment company that invests in hedge funds --

rather than investing in individual securities. Some funds of hedge funds register

their securities with the SEC. These funds of hedge funds must provide investors

with a prospectus and must file certain reports quarterly with the SEC.

Not all funds of hedge funds register with the SEC. Many registered funds of

hedge funds have much lower investment minimums (e.g., $25,000) than

individual hedge funds. Thus, some investors that would be unable to invest in a

hedge fund directly may be able to purchase shares of registered funds of hedge

funds.”6

Funds of Hedge Funds have experienced a rapid growth within a limited amount

of time. They are pooled investment products that invest their capital among

several hedge funds, from 20 to 40. They might be diversified or concentrated on

few funds, or to a strategy, style or even region and they are usually promoted

and set up by large institutional managers, who raise funds and invest in a

portfolio of individual, unregistered hedge funds.

Funds of funds have some important advantages. First of all, they open up the

alternative investment universe to small investors. Secondly, they give the

possibility to indirectly invest in individual hedge funds and finally, they offer

the possibility to automatically exploit benefits from diversification.

► Hedge funds were once an exclusive investment vehicle for wealthy and rich

investors. Nowadays regular investors or new entrants, who are less well off and

have smaller investable assets, can take part to the action thanks to Funds of

Hedge Funds. Since they are often registered, FoFs require lower minimum

investments, less strict income and net worth requirements, shorter lock-ups and

can be offered to an unlimited number of investors.

Differently from hedge funds’ institutional investors, funds of funds’ retail

investors would not find attractive illiquid investment such as the one in hedge

funds. Relative to the underlying hedge funds, FoFs are characterized by looser

withdrawal restrictions and illiquidity features, such as quarterly withdrawal

6 SEC (2008), Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds, from the internet: www.sec.gov/answers/hedge.htm

options. Thus, they are more marketable to retail investors and they give to small

investors the opportunity to enter the hedge fund industry

► When investing in hedge funds, it is fundamental to understand the risk-return

profile and the likelihood of large drawdowns of each manager. Experience and

qualitative judgement both play an important role.

Small investors, without previous experience in this asset class, are usually not

able to assess an hedge fund. FoFs allow such investors to enter the hedge fund

arena by delegating to professional managers the selection process and the choice

of individual funds. FoFs’ managers usually perform a professional due-diligence

process and run several background checks on hedge funds before investing.

They verify the credentials and check the references of the funds’ managers, they

continuously monitor the hedge funds included in their portfolio. In other words,

investors entrust skilled professionals with all the time-consuming due diligence

tasks. Not only FoFs managers are more competent and better equipped for

performing due diligence and for picking the right funds, but they are also in a

better position: they could have a competitive advantage, consisting in lower

costs to obtain contacts, information, insights and they could even know when a

skilled professional is going to launch an hedge fund before the others know.

It goes without saying that due diligence is a relevant part – and probably the

most relevant – of the FoFs managers’ value proposition.

► Hedge fund industry is quite heterogeneous. It is indeed made of funds

pursuing several different strategies with low historical correlations among hedge

funds themselves as well as bonds and stocks. The diversification benefits can be

exploited in order to construct and manage portfolios of hedge funds, thereby

diversifying idiosyncratic risk of the underlying funds, i.e., the risk related to

single investing strategies and managers’ style. For instance, the weaknesses of

one manager can be diversified investing in the strengths of another fund

manager.

FoFs allow investors to accede a number of fund returns with one investment.

Rather than assuming the risk of selecting one or more individual managers,

FoFs give investors the opportunity to allocate their money to a portfolio of

managers thereby achieving a likely more constant and stable return, due to the

avoidance of large drawdowns. This is in line with the objective of absolute-

return managers, who purse positive and stable returns, while avoiding negative

compounding of the capital under management.

In addition, we have to consider that diversification benefits deriving from

investing in several individual hedge funds are usually not fully exploited by

retail investors because they face illiquidity problems. In addition to that, hedge

funds are also perceived as being too loosely regulated and not transparent. FoFs,

on the other side, do offer diversification opportunities and they are more likely

to provide performance reports to investors and to be audited.

Chart 1.4: Manager and Strategy Diversification

Source: AIMA’s Roadmap to Hedge Funds – November 2008

Chart 1.4 shows some of the investment vehicles within the hedge fund industry.

Single-strategy hedge funds do not offer manager nor strategy diversification.

Even though multi-strategy funds are sometimes compared to funds of funds,

they do not offer manager diversification and hence are riskier. However, a

multi-strategy manager could be quicker and more flexible in reallocating capital.

► The most important disadvantage is the double-fee structure. “Funds of hedge

funds typically charge a fee for managing your assets, and some may also

include a performance fee based on profits. These fees are charged in addition to

any fees paid to the underlying hedge funds. If you invest in hedge funds through

a fund of hedge funds, you will pay two layers of fees: the fees of the fund of

hedge funds and the fees charged by the underlying hedge funds.”7

Relative to individual hedge funds, funds of funds usually charge lower

performance fees to their investors, usually 10%. The reason is that, by investing

in underlying funds, FoFs’ managers delegate the allocation to the individual

securities to the sub-funds themselves. However, there are higher management

fees, ranging between 2% and 3% of AUM. If the average hedge fund charges a

fee structure of 1.5% and 20% of the profits, the overall cost for an investor in a

FoF would be 3.5%-4.5% of the AUM and 30% of the gains.

The reason behind this double-fee structure is that investors have to compensate

both the manager of the individual hedge fund and the FoF manager. The former

for managing risk at the security and market level and the latter for his skills in

constructing a balanced portfolio, managing risk at sub-fund level, selecting and

monitoring the sub-funds

► Another important disadvantage is that it is still difficult to diversify the risk at

the individual security level. For instance, the underlying funds might be all

betting on the same individual securities. Thus, the fund of funds and its

investors might end up being exposed to a large amount of idiosyncratic risk,

related to the same securities through several different funds. In addition, they

could be unaware of the situation because of the lack of reporting of the hedge

funds.

7 SEC (2008), Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds, from the internet: www.sec.gov/answers/hedge.htm

► Finally, there is the risk of over-diversification. FoFs managers must be careful

about the number and the type of individual hedge funds they pick up. They have

to coordinate the different holdings and avoid adding too many sub-funds.

1.8 Hedge fund due diligence

As already pointed out earlier, hedge funds can be defined as a “pure skill asset

class”, meaning that their performance and results highly depend on the

capabilities and skills of people that are managing the fund. Trying to replicate

strategies that worked well in the past is not a good idea; managers need to have

a solid grasp of the strategy they are investing into and of the situation that

markets are currently experiencing.

The investment process starts with the manager selection, and the evaluation and

identification of the right manager is key to success. Choosing a manager is

extremely important and truly makes the difference, both for individual investors

selecting a fund of funds or for institutional investors and FoFs selecting an

individual fund. For instance, each manager has its own investment style and can

have a competitive advantage over the rest of the market in a particular field.

Each manager can be prone to directional or non-directional strategies.

Fundamental for evaluating and selecting a manager is the due diligence. This

process consists in the evaluation and research of several information, such as

financial and legal documentation, operational infrastructure and investment

terms. Among the other things to look for and analyze, investors should have a

clear understanding of the fund’s investment strategy and valuation process, the

people, the organization and the track record.

► About the investment process, it is necessary to investigate the fund’s

investment policies, process, the execution and the risk management policies.

Also, the use of leverage, short-selling and liquidity features. To this extent, the

Offering Memorandum, the fund’s prospectus and the related materials are

important documents because they contain legally bounding statements. They are

fundamental in order to understand the level of risk characterizing the fund's

investment strategies, to assess whether such strategies are suitable to the

investors’ personal goals, time horizons, and risk tolerance.

► Investors should have a clear understanding of the valuation process of the

fund’s assets. It is extremely important to know how the fund's assets are valued

because FoFs and hedge funds usually invest a really high percentage of their

portfolio in illiquid securities that may be difficult to value. To add to an

investor’s anxiety, managers use significant discretion in valuing securities and

they are sometimes allowed to select the price that they think best reflects market

value among a wide range of prices.

Investors must be aware of the risks of potential manipulation, from period to

period, related to the excessive use of discretion, especially because they are

paying management and performance fees on the base of these subjective

valuations. They should check whether a pricing/valuation committee exists to

oversee managers during the implementation and execution of the valuation

process. Such a committee would bring greater accountability and transparency

to the whole process and avoid too much discretion to the hedge fund in pricing

securities.

► Experience and background of the fund managers need to be carefully

analyzed. To this extent, investors shall research the backgrounds of hedge fund

managers, so as to know with whom they are investing, to whom they are

entrusting their money. They shall be sure of whether hedge fund managers are

qualified to manage their money. It is also important to understand whether the

fund adopts a team or one man-approach.

► Investors should carefully check the organization: whether the business plan of

the hedge fund is clear or not, the way managers plan to raise money for the

future, whether a retention plan for the key people and internal audit procedures

are in place.

► The analysis of the hedge fund track record and history within the securities

industry is also important, even if it is usually not easy due to the well known

lack of transparency.

Additionally, in a due diligence process qualitative judgement is as important as

quantitative analyses. In other words, investors have to go beyond traditional,

quantitative analysis and must take a non-conventional approach towards due

diligence. They must ask critical questions to managers, regardless of their

reputation, about topics that cannot be found in any financial statement or data-

room. This is extremely important to avoid blow-ups, to have an edge and

maximise returns. In other words, since they are entrusting their own money to

someone else, investors should not be afraid of asking questions. They should

carefully understand where their money is going, where it is being invested, who

and how is managing it, how and when they can effectively withdraw their

money, what protections they have and the rights they hold as investors.

“It’s a question of thoroughly reviewing the materials that the funds provide,

looking at legal documents, having a thorough due diligence questionnaire,

going on-site and meeting the various members of the team in the front- and

back-office areas, understanding the liquidity, leverage, concentration,

conducting reference checks, understanding the source of returns, and above all,

being sceptical of the answers,” says Adrian Sales, head of due diligence at

Albourne Partners8.

As Blaine Klusky of AIG suggests, it could be useful to separate operations team

from investment team during the due diligence meetings, collect answers to the

same questions and ultimately compare them. The most candid people can be a

trustworthy source of information for the future. Especially because insiders

usually know when and if something is happening before the investors know.

Investors have to check whether senior managers and key staff attend meetings

or they are usually absent. It could be also useful to understand whether

8 Kvasager W. (2009), Due diligence is all about legwork, 5th April. From the Internet: http://www.ft.com/cms/s/0/0717ce3c-21b2-11de-8380-00144feabdc0.html?nclick_check=1

employers and staff members are bound by non-disclosure agreements and

whether former employers are indemnified in a way that the fund is protected

from potential retaliation. Other questions can be addressed to the way

management fees are used. Such money should be destined to the payment of

operating expenses, not to enrich the managers. It is also important to realize that

when investing in a FoF, investors are going to pay two layers of fees.

Due diligence is a never ending, dynamic process. After evaluation and selection,

investors need to constantly review managers within their portfolio. It is a

continual process because relevant factors of both markets and strategies may

change overtime, so that managers have to adapt to change and implement risk

management mechanisms.

1.9 Hedge Fund Replication Strategy

Many authors are currently addressing the issue of whether hedge fund managers

are actually active managers or they just collect risk premia from the market. The

scepticism surrounding the effective possibility of alpha-generation in a crowded

market and perhaps the onerous 2%-20% fee structure of the hedge fund industry

are making the investor community shift the attention to a new strategy: hedge

fund replication. This strategy is conceived to replicate hedge funds’ returns at

lower costs and higher liquidity features.

Bill Fung and Narayan Naik at London Business School, and David Hsieh of

Duke University found that about 85% of the average fund of hedge funds’

returns can be explained by a collection of rewards for bearing some common

forms of risk premia (or beta). Their main idea is that if hedge fund returns can

be explained by few forms of market exposure, then it is possible to construct a

portfolio of general market exposure that allows achieving returns that look like

hedge fund returns. Put differently, it is possible to achieve FoFs-like returns by

investing in the risk factors that tend to drive hedge fund returns.

To them it is possible to construct a synthetic hedge fund, using derivatives and

other commonly traded instruments, consisting of a diversified collection of beta

exposures that explains the majority of FoFs’ index returns.

In particular, they use a multi-factor model with a changing basket of eight

factors, such as market risk premium, credit premium, term premium, emerging

markets premium, small-cap premium and other dynamic beta which can be

considered as trading strategies that mechanically buy and sell options on

certain assets – government bonds, currencies and commodities – as prices rise

and fall, thus capturing non-linear returns.

This synthetic hedge fund is a portfolio aimed to replicate FoFs’ returns coming

from the universe of strategies that are being tracked, for the part that is

attributable to the assets and strategies that rise (or fall) in value, independently

of the manager’s decisions, namely the beta part. Moreover, the beta exposures

can be obtained through liquid instruments, low transaction costs and fees and no

manager-specific risk, thereby representing a convenient and appealing

alternative to the costly, illiquid and direct exposure to hedge funds.

Hedge fund replication delivers FoFs-like returns through transparent, liquid, and

low-cost exposure to the risk premia that drive the majority of hedge fund

returns. This extremely important, especially in the light of last year’s credit

crunch, which underscored liquidity issues within hedge fund portfolios and

extended lock-ups in many cases.

According to Narayan Naik, “…hedge funds try to innovate, but once some

strategies become mainstream, the beta component can often be replicated. The

more directional it is, the easier it is to capture.” 9

To be noted that synthetic hedge funds just capture the beta part of FoFs’ returns,

not the alpha, thus forgoing the manager-specific excess return potential.

However, the replication strategy starts from the observation that if any alpha is

generated by hedge fund managers, it is almost entirely eroded by the fee

9 Bishop B., Fieldhouse S. and Jones R. (2008), Hedge Fund Replication: A Revolution in the Making?, The Hedge Fund Journal, May.

structure. In other words, FoFs’ index returns have little after-tax return in excess

of what achieved thanks to the replication strategy.

If the objective is to track hedge funds or FoFs’ performance, then the question is

why not investing directly in a fund of funds or buying an index. Advocates of

the replication strategy say that many well-performing funds have capacity

constraints, i.e., they are closed to new investors. Secondly, even if investors

have the possibility to allocate their assets to such indexes, the performance of

hedge funds is usually considered to be upwardly biased. For instance, funds are

selected for an index because they performed particularly well in the reference

period, while funds that failed are not considered. In other words, the index is

made up of funds that survived and not of all the set of funds throughout the

period of consideration.

Among the benefits of replication strategies, there is also the fact that they

employ only liquid strategies such as equity index futures. Hence, they do not

suffer the typical liquidity risk faced by almost all hedge fund strategies.

Replication strategies usually offer daily liquidity features for investors, and

weekly liquidity in the worst case.

Usually when managers and investors look at return volatility or Sharpe ratio as

proxies for risk they implicitly ignore liquidity issues and other operational risk

factors, such as fat tail risk and fraud which is heightened by lack of

transparency. If hedge fund replication succeeds in eliminating liquidity risk it

means that it delivers superior risk-adjusted returns when liquidity risk and the

other risk factors are taken into account.

FoFs replication also allows investors to accomplish other tasks, such as

rebalancing the portfolio or temporarily allocating their assets. Indeed, it is

possible to use the replication strategy to add exposure (percentage on total

portfolio value) to the hedge fund asset class, while maintaining liquidity, in case

the exposure dropped too much because of poor performance. Or, it can be used

to reduce exposure if it was above the optimal level because of good

performance.

Replication strategy also provides immediate exposure to hedge fund asset class

for temporary purposes. For instance, during the transition from one hedge fund

manager to a new one, a fund of fund could need time in order to perform due

diligence or it could be that the liquidity features of the two funds are not

coordinated so that a temporary, immediate and liquid allocation to the hedge

fund asset class is needed. FoFs might also need exposure to meet the required

investment profile when there are no available hedge fund managers that fit with

the desired criteria.

Thirdly, investors can use this strategy to implement a core/satellite approach.

Replication allows making a passive allocation to access beta, thus being the

passive part of the portfolio. Investing directly in the hedge fund industry to seek

alpha can be instead considered as the active part of the portfolio. Hence, both

the core and the satellite parts of the portfolio would be invested in the same

asset class, but investors can decide to pay the onerous hedge fund-like fees only

when they do identify genuine hedge fund alpha producers. Replication is a good

starting point for new brand investors entering the hedge fund asset class, and

then adding other direct and specific investments to supplement it. Existing

investors or funds of funds, on the other side, could turn to replication to add

exposure to some hedge fund strategies that they are missing.

Lastly, replication offers investors, including funds of funds, a cheap and cost

effective means to mirror the beta in more restricted universes, such as particular

sub-strategies.

Although hedge fund replication is still a new investment tool, it is rapidly

gaining interest within the investors’ community. Interestingly, FoFs look at

replication as a useful investment tool as well, a complement to individual hedge

funds investing. Not surprisingly, hedge funds tend to see replication as a

competitor.

CHAPTER 2

2.1: Assets Under Management; 2.2: 2008 Key Performance Facts; 2.2.1: Individual Strategy

Performance; 2.3: 2009 Overall Performance; 2.4: Performance of single strategies in 2009; 2.4.1:

Convertible Arbitrage; 2.4.2: Emerging Markets; 2.4.3: Managed Futures; 2.4.4: Fixed-Income Arbitrage;

Measuring the performance of the hedge fund industry is far from being an easy

task. Hedge fund managers report performance data to databases on a voluntary

basis and they tend to stop reporting when performance gets really poor, thus

creating a selection bias. As a consequence, they usually exit the database also

for reasons other than liquidation.

In addition, estimates on performance are affected by the survivorship bias, i.e.

the fact that hedge fund industry’s returns for a particular year do not take

account of hedge funds that closed during that year, which makes the overall

results positively skewed.

Since data providers conduct their own researches to generate estimates, there are

no official figures and/or definitive sources for performance data on the industry.

It goes without saying that they could vary among different databases and data

sources.

In this chapter, I will make use of the Credit Suisse/Tremont Hedge Fund Index,

as a proxy for the whole hedge fund industry. The Index is based on the Credit

Suisse/Tremont database, which tracks over 5000 funds. It is made up of only of

funds with minimum assets under management of $50m, a 12-month track

record, and audited financial statements. It is calculated and rebalanced on a

monthly basis, and shown net of all performance fees and expenses.

2.1 Assets Under Management

After a decade of high growth, the hedge fund industry is now experiencing a

tremendous shock. With liquidity squeeze and extreme market conditions on the

one hand and global deleveraging on the other hand, hedge funds have tried to

withstand placing liquidity restrictions, thus trying to break through the

downward spiral of the last two quarters of 2008. Credit Suisse estimates that, as

December 2008, 11.6 percent of total industry assets under management (AUM)

was impaired, meaning suspended redemptions, gate provisions or side-pocketed

assets.

According to the International Financial Services London (IFSL) estimates, the

hedge fund AUM have felt slightly more than 30 percent in 2008 to $1,500bn10.

A research from Morgan Stanley shows that total assets of the industry were

down to about $1,330bn at the end of March 2009.

Chart 2.1: Global hedge funds

0

0.5

1

1.5

2

2.5

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Trill

ion

Ass

ets

3000

4000

5000

6000

7000

8000

9000

10000

11000

12000

AUM Number

Source: IFSL estimates

Overall, the size of the industry has declined because of a combination of two

main factors. Namely, the negative performance and asset outflows due to

liquidations of funds and increase in redemptions.

IFSL also estimates that the record decline in assets during 2008 was split

relatively equally between negative performance and asset outflows. Moreover, 10 All the data and estimates in this paragraph are from IFSL.

redemptions had a bigger impact in Europe and emerging markets, while in the

US and Japan, losses on investments were more responsible for the decline in

assets. Lastly, Asia experienced the highest rate of liquidations. The balance

between performance and asset flows on industry assets over different years is

shown in Chart 2.2.

Chart 2.2: Net asset flow and returns

-350

-300-250

-200

-150

-100-50

0

50100

150

200

250300

2000 2001 2002 2003 2004 2005 2006 2007 2008

Net Asset Flow Performance based growth/decline

Source: IFSL estimates

► Hedge funds losses were widespread in 2008, with almost 75 percent of global

funds recording a negative performance and an annual cumulative loss of 19

percent. The Credit Suisse/Tremont Hedge Fund Index reported the second worst

quarterly performance in the last quarter 2008 and then posted a positive 0.85

percent in the first quarter 2009. Nevertheless hedge funds outperformed the

S&P and many of the underlying markets, developed and emerging stock market

indices, and aggregated commodity indices. It underperformed bond market

indices and cash.

► It is estimated that the industry lost nearly 30 percent of assets in 2008 or

almost $650bn down to $1.500bn. Of total losses, approximately half of them

were lost as a direct consequence of investor redemptions. Monthly net flows

started to turn negative in the second half of 2008. By the end of third quarter,

outflows were starting to reverse inflows from the rest of the year. The fourth

quarter was even worse, with redemptions reaching record levels of $150bn.

The surge in redemptions was due to the dissatisfaction of the performance

during 2008. In other words, investors were unhappy because of the huge losses

characterizing the hedge fund industry. In addition, many investors were forced

to cover their losses or cash calls elsewhere, so they had to recall their

investments in hedge funds. Lastly, there has been an increase in risk aversion

and a decrease in investors’ confidence because of the reputational damage

inflicted by the Madoff fraud.

Overall, the positive flows in the hedge fund industry of the first half of 2008

were more than offset by the outflows of the second half, even though many

hedge funds suspended redemptions toward the end of 2008 because they feared

that selling illiquid assets at a low price in order to repay investors would have

exposed remaining investors to even bigger losses.

Hedge funds have continued to post negative cumulative flows also in 2009,

$103bn and $42.8bn in the first and second quarter respectively, according to

Hedge Fund Research. In particular, the first quarter was characterized by

sustained volatility levels and a deterioration of the macro picture. Then,

investors have continued to pull money out of funds as restrictions on

redemptions were lifted by the funds.

The second quarter saw the investors’ risk appetite growing and a trend reversal

in many strategies. In particular, institutional investors seems to be getting back

while private clients are not giving much signs. Moreover, many deleveraging

constraints for hedge funds were eased. Some bigger established hedge funds

also enjoyed some small inflows but the majority of hedge funds continued to

suffer from outflows as they lifted redemptions’ restrictions.

While the industry is still experiencing net outflows, certain strategies have

begun to see inflows returning and managers expect to see a trend reversal

through the remainder of 2009 as investors regain confidence in the ability of

hedge funds to generate returns.

► A lot of funds have been forced to close because they incurred in severe losses

or because the pressure posed by redemptions combined with lack of liquidity

was unbearable. Investors’ redemptions indeed caused a cycle of further

redemptions and heavy losses. Since the stock market registered heavy losses in

September and October 2008, regulatory agencies in many jurisdictions imposed

restrictions on stocks’ short-sales. This ban further worsened the situation and

many hedge funds were forced to close their positions.

Olympia research found that 28 percent of the funds reporting to the Hedge Fund

Research database (HFR), a leading provider of hedge fund industry data, in the

beginning of 2008 were no longer there at the beginning of 2009. This attrition

rate, which is the percentage of funds that have ceased to report their returns to

the database for the year 2008, is much larger than the average rate of 8.7 percent

observed between 1995 and 200411. It is an interesting estimate since academic

research has shown that the liquidation rate, i.e. the percentage of funds exiting

the database for liquidation reasons only, is historically half of the attrition rate12.

Hedge funds can indeed exit the database for several reasons such as liquidation,

merger, huge losses or closing to new investors. However, in the current

environment it is likely that most hedge funds’ exits are due to liquidations.

IFSL instead found that the number of hedge funds fell by 10 percent in 2008 to

around 10.000, as shown in chart 2.1, with most closures coming in the latter part

of the year.

Many large hedge funds around the world have begun to experience net money

inflows and investors, especially institutional ones such as pension funds, are

currently thinking to increase their allocations. Pension funds have to face the

pressure of delivering higher returns on their portfolios and thus are extremely 11 Liang B. and H. Park (2008), Predicting Hedge Fund Failure: A Comparison of Risk Measures, Working paper. 12 Baba N. and Goko H. (2006), Survival Analysis of Hedge Funds, Bank of Japan Working Paper Series.

interested in the recent performance of hedge funds. The Universities

Superannuation Scheme, the UK’s second-largest pension fund, has just

announced in July that it is going to quintupling its hedge fund allocation to

about $1.25bn over the next two years.

Money flows are expected to turn positive also for the majority of the hedge

funds in the next months as investors will start to reallocate their funds to the

industry and move away from cash. Investors are supported by the positive

quarterly performance obtained by many funds and strategies in the recent

months. However, institutional investors have large amount of money at the

disposal and will likely allocate many of them to the industry, so hedge funds are

expected to close the doors to new investors before too long.

HFR suggests that the hedge fund industry currently manages assets worth

$1,430bn, $100 more than its lowest value at the end of this March, of which 9.6

percent is currently impaired.

Chart 2.3 shows the evolution of AUM for each strategy during the last 15 years.

According to Credit Suisse/Tremont Equity market neutral have raised interest

over time while Global Macro has less investors’ consensus today than in the last

decade.

CS/Tremont estimates that Dedicated Short hedge funds account for less than 1

percent of all strategies. This is a very interesting result, especially in light of all

the criticism short sellers have faced recently.

HFR also estimates that liquidations fell by 50 percent in the first quarter of 2009

with respect to the levels of the prior quarters, whereas new fund launches

accelerated, with approximately 150 funds entering the market.

Chart 2.3: Hedge Funds Assets by strategy over time

Source: Credit Suisse /Tremont

2.2 2008 Key Performance Facts

2008 has been a tremendous year for most asset classes, including hedge funds.

The industry posted drawdowns that rank among the worst in its history and

suffered heavy losses following extraordinary events in the marketplace.

Investors had a reminder that hedge funds are exposed to several risk factors,

such as credit risk, liquidity risk and a variety of equity risk factors.

It has been estimated that Lehman Brothers controlled approximately 5 percent

of the global prime brokerage business, so it can be imagined that the hedge fund

experienced negative effects after the company’s collapse. However,

strengthened by the previous and not so far experience of Bear Stearns, many big

funds had already moved their assets to other prime brokers in order to obtain an

adequate level of prime broker diversification and better manage counterparty

risk. Nevertheless, smaller funds that relied on fewer prime brokers were harder

hit and those sectors characterized by a large percentage of small funds were

harder impacted.

The Lehman bankruptcy affected also prime brokers which became more risk

averse and increased margin requirements. Managers had consequently to raise

cash in order to meet prime brokers’ increasing margin demands and thus faced

an even higher pressure to sell assets even at depressed prices.

Although the short sale bans, implemented as a response to weakening financial

markets, varied across different jurisdictions and by regulator, they globally

affected some strategies and sectors. In particular, funds following the

Convertible Arbitrage strategy were not able to hedge anymore.

In December 2008 Bernard Madoff was charged with security fraud by federal

prosecutors and was sued by the SEC for a multi-billion dollar Ponzi scheme.

This event damaged the reputation of the hedge fund industry and affected

investors’ confidence. Moreover, managers are expecting a more stringent

regulation for the future.

The combination of these unprecedented events caused extreme market volatility

and forced governments and central banks to intervene several times.

Chart 2.4: Volatility measured by the VIX Index

Source: Yahoo! Finance

Chart 2.4 shows the level of expected volatility during the past year as measured

by the Volatility Index (VIX)13, a common measure of market risk. The VIX

experienced a large upward swing in the third quarter 2008, between the

beginning of September and the end of October. Usually there is a negative

correlation between the VIX index and the underlying S&P 500, especially in

periods when investors are feared and less confident. This happened in 2008 as

well.

To check whether the 2008 volatility level was high we can compare 2008 VIX

values with historical ones. In 2008, 90 percent of the observations were between

19.64 and 67.7 while only 5 percent were below 19.64. Historically, almost half

of the observations, that is 45 percent, were between 19.01 and 34.35 with just 5

percent of observations higher than 34.35. It also interesting to note that the 95

percent percentile of 2007 is almost near to the median of 2008. Such

considerations lead to the conclusion that 2008 values have been extremely high.

Chart 2.5: Historical CBOE VIX index values

Percentiles Year Number of observations 5% 50% 95%

1986-2008 5782 11.60 19.01 34.35 2005 252 10.75 12.52 15.58 2006 251 10.52 12.00 17.73 2007 251 10.34 16.33 26.48 2008 240 19.64 23.79 67.70

Source: IDEMagazine – Borsa Italiana

The high levels of volatility intensified the de-leverage effect on the hedge fund

industry because managers had to de-lever and reduce risk in order to be able to

face in a better way the reversals in the marketplace. The increasing funding

costs compounded the pressure.

Chart 2.6: Libor – OIS spread

13 The Chicago Board Options Exchange VIX is a measure of the expected volatility over a period of 30 days, that is the fear of market participants. It is calculated as implicit volatility from the prices of both At the Money and Out of the Money options on the S&P500 index.

Source: Bloomberg.com

As we can see from chart 2.6 the Libor-OIS spread, i.e. the difference between

the Libor rate and the Overnight Index Swap (OIS), widened in 2008. The

average spread was below 1 percent for most of 2008 but then the spread started

to skyrocket in September, reaching its peak around 3.6 percent in mid-October.

The widening of this spread signals that the credit markets are becoming

unhealthy. In 2008 they were freezing up indeed. What happened is that banks

started to understand and to worry about the significant mismatch between assets

and liabilities on each other’s balance sheet and that led to a total breakdown in

interbank lending. In other words, banks lost confidence in each other.

The main effect of banks’ unwillingness to lend is that credit was not so easily

accessible anymore, so it got harder to obtain financing. Capital lines for

businesses and consumer lending completely disappeared. Since capital available

for lending activities reduced, funding costs raised for all market participants.

Hedge fund managers came under significant pressure and were forced to reduce

their position sizes, shift to cash and de-lever.

The S&P 500 index lost more than 37 percent. Most of this fall took place in the

last part of the year. In October, the S&P 500 lost almost 17 percent while it

registered losses of about 9 and 7 percent in September and November

respectively.

The MSCI world index was down 42 percent and experienced a slightly higher

volatility during the year. Emerging markets performed poorly and were hit with

even greater losses. The MSCI emerging markets index, which includes 22

emerging markets country indices, fell by about 54 percent in 2008. It

experienced extreme drawdowns in the second part of the year thus registering an

high level of volatility.

Chart 2.7: Comparative Index Annual Returns and Standard Deviations (2008)

CS/Tremont S&P500MSCI World

MSCI Emerg. Markets

S&P CSGI

Global Bond

Annual Return -19.1% -37.6% -42.1% -54.5% -46.5% 0.8% Annual St. Dev. 9.8% 20.9% 23.6% 37.4% 42.9% 6.1%

Source: Bloomberg.com, hedgeindex.com and standardandpoors.com

After the progression in 2007, commodity prices felt in 2008. The S&P GSCI,

recognized as a leading measure of general price movements and inflation in the

world economy and as an indicator for commodity markets, fell by more than 46

percent. As equity markets started falling investors moved to fixed income

investments in what is generally called a flight to safety. Indeed, the Barclays

Global Investors Bond Index finished the year in positive.

Chart 2.8: 2008 Comparative Index Monthly Returns (January 2008 – December 2008)

-30%

-27%

-24%

-21%

-18%

-15%

-12%

-9%

-6%

-3%

0%

3%

6%

9%

12%

1 2 3 4 5 6 7 8 9 10 11 12

CS/T Broad Index S&P 500 MSCI World MSCI Emerging Markets Global Bond

Source: Bloomberg.com and hedgeindex.com

The hedge fund industry finished the year 19 percent down as measured by the

Credit Suisse/Tremont Hedge Fund Broad Index. As shown in chart 2.8, both

hedge funds and equity indices fell sharply as volatility increased. Hedge funds

suffered the most in September, October and November when they registered

some of the worst months in their history. The CS/T Broad Index posted monthly

losses of 6.5, 6.3 and 4.1 percent during these three months but it performed

better than broad equity indices and commodity markets by limiting drawdowns

and maintaining considerably less volatility.

The broad picture of the year is that hedge funds generally beat stock market

indices. Put differently, we could say that equity markets experienced an awful

year while hedge funds as a group a bad one and they came nowhere near beating

bonds or cash.

2.2.1 Individual Strategy Performance

While financial markets suffered and overall performance for the industry was

negative, not all hedge funds and investment strategies lost money during 2008.

Some funds were able to generate alpha despite the adverse market conditions.

According to the Credit Suisse/ Tremont database, Managed Futures and

Dedicated Short Bias, which typically perform well in market downturns,

registered double digit positive returns.

► Managed Futures in particular benefitted from the short positions in equities

and commodities and long exposure to treasury bonds, thus handily beating the

overall markets. The last quarter 2008, which was characterized by a clear

downward trend, generated almost the 60 percent of the total annual return of

18.33 percent for the strategy, that is 10.9 percent.

Managers operating in this space benefit from directional bias and turmoil and

attempt to realize profits from trends, either upward or downward, by buying

long or selling short, holding on to positions for as long as the trend is intact.

Since they try to profit from directional volatility, the past year has been

particularly fertile for them because financial instability and the uncertain

regulatory environment have created the perfect stage, thus triggering the

positive performance.

Dedicated Short Bias continued to stand out with good returns and strongly

benefitted from the sharp decline in equity markets, as it is characterized by a

dominant short exposure to stock markets.

► Emerging markets strategy was negatively affected by the fall in emerging

equity markets, which significantly underperformed developed equity markets,

across the globe and by the weakening of respective currencies. Since June 2008

the MSCI Emerging markets reported phenomenally disappointing losses,

performing worse than both the S&P 500 and the MSCI World Index. Investors

witnessed the most severe correction in emerging market equity history amid

levels of market volatility and uncertainty that were truly exceptional.

The widespread collapse of investors’ appetite for risky assets, together with the

rapid deleveraging led to an indiscriminate emerging market sell-off, involving

not only countries with structural imbalances such as the Eastern Europe ones but

also stronger economies which were probably better placed than developed world

to withstand the global economic and financial crisis.

Together with the move away from riskier assets, emerging markets were hit by

the falling commodity prices which amplified the selling pressure on emerging

countries seen as particularly reliant on commodity-derived revenues. The S&P

GSCI reported negative returns for all the six months of the second part of 2008,

thus reaching a -46.5 percent annual loss at the end of the year.

However, both equity markets and currencies began to strengthen in December,

thus leading to positive results for managers investing in this space.

► Convertible arbitrage managers were significantly affected by the global ban

on equity short-selling because they were not able to hedge their long exposures

with short positions on corresponding stocks.

During 2008 equity markets experienced high levels of volatility, risk aversion

increased, credit markets worsened and hedge fund were more and more

pressured by redemptions and deleveraging constraints, so they were forced to

continue selling, in many cases at reduced prices, in order to raise cash.

The sell-off in the convertible space and the fact that equities were dropping, thus

reducing the value related to the equity options as they were going out-of-the-

money, depressed the value of convertibles and led to an extensive devaluation.

According to Barclays Capital, the US convertible market went down from a

value of $345.4bn to $190bn from December 2007 to December 2008, shrinking

approximately 45%. If we add Asia and EMEA the market size of global

convertibles was approximately $350bn as of March 2009.

► Among the worst performers there was also equity market neutral strategy

However, the strategy seems to have withstood the equity market decline better

than other strategies for most of the year and the poor performance of the fourth

quarter happened almost exclusively as a result of the scandal surrounding

Madoff, as he managed the assets of some funds in the space.

2.3 2009 Overall Performance

2009 has seen major economies worldwide introducing aggressive economic

stimulus plans while central banks across the globe have maintained low interest

rates and intervened where necessary. The markets were also encouraged by the

stress tests conducted on largest banks by the US Government and by other

countries. As we can see from chart 2.6, the Libor-OIS spread has narrowed

during the first half of the year, signalling that credit markets were becoming

healthier and less tight while confidence was increasing. In particular, the spread

is decreasing to its historical levels, meaning that financing costs and credit

conditions are coming back to normal levels.

After a challenging 2008, hedge funds have started performing better in 2009.

They experienced an inversion of the second half of last year and posted the best

start to a year in a decade as markets are recovering. Hedge funds, as measured

by the CS/Tremont Broad Index, have registered positive returns for both the first

and second quarter 2009 and for seven out the first eight months in 2009, as

shown in chart 2.9.

Apparently, hedge funds have been able to avoid large drawdowns in the first

two months despite the losses of major equity markets. Then, they maintained a

relatively defensive position in the following months when all the broad equity

indices were posting large positive returns, thus limiting the negative effects of

elevated volatility. Just as like as they fell less than equity markets last year, this

year hedge funds are rising to a lower extent.

Chart 2.9: 2009 Comparative Index Monthly Returns (January 2009 – August 2009)

-15%

-12%

-9%

-6%

-3%

0%

3%

6%

9%

12%

15%

18%

21%

1 2 3 4 5 6 7 8

CS/T Broad Index S&P 500 MSCI World MSCI Em. Mkts Global Bond

Source: Bloomberg.com and hedgeindex.com

The first quarter saw hedge funds outperforming traditional equity and bond

indices. During the second quarter the investors community regained the risk

appetite lost in the last part of 2008 as equity markets rallied. According to Credit

Suisse Research, investors approached the levels of risk appetite that

characterized the period before the Lehman collapse. However, the VIX

volatility index registered large upward swings in June after it decreased in the

first part of the year. These market movements created difficulties in the equity

space but hedge funds were able to avoid drawdowns and registered positive

returns in June as well.

The VIX index continued to decrease and reached 23.09 in July, its lowest level

since September 2008, and in the same month equity indices registered good

results while hedge funds maintained their defensive position vis-à-vis the

markets. Hedge funds continued to perform well but less than equities in August,

a month in which there was great concern by economist on whether markets

would continue to rally or not.

According to the Credit Suisse/Tremont Broad Index, at the end of August the

industry was up almost 11.57 percent since the beginning of 2009, or 17.9

percent on a yearly basis. By looking at annualized returns it is clear that hedge

funds succeeded in keeping volatility low despite the large swings of the VIX

index in June and July. Interestingly, the industry has performed slightly below

the S&P 500 index. In August, emerging market equities were up almost 50

percent from their level at the end of last year, or 80 percent on a yearly basis,

thus making their way back after a disastrous 2008.

Chart 2.10: Comparative Index Annual Returns and Standard Deviations (2009)

CS/Tremont S&P500MSCI World

MSCI Emerg. Markets

S&P CSGI

Global Bond

Annual Return 17.9% 20.1% 28.1% 80.1% 6.8% 2.0% Annual St. Dev. 5.1% 26.9% 28.5% 34.7% 30.0% 2.8%

Source: Bloomberg.com, hedgeindex.com and standardandpoors.com

Although returns may vary significantly in different years, hedge funds have

typically outperformed the S&P in recent years. The point is that they did not

beat cash last year, whereas this year they are succeeding in beating both stock

and bond market indices and cash in risk-adjusted terms.

Indices seem to agree on the fact that the industry did well and was successful in

repositioning itself. Hedge funds have been able to avoid large negative returns

and maintain lower levels of volatility with respect to the broad equity indices

that registered large positive as well as large negative returns.

The performance of hedge funds through the first half of this year also suggests

that hedge fund industry may be considered as a good diversifier during

normalizing markets. It can offer diversification benefits and this probably

explains the renewed interest of investors in the potential of the asset class.

Money outflows are smaller in scale but they are still there. It is likely that the

outflow process will continue and many more hedge funds will be eliminated

from the market, making room for more successful and larger hedge funds. The

result is that there will be more place for remaining funds and trades will be less

crowded, so that any arbitrage strategy has the potential to outperform. Hedge

funds will not have to take too much risk to generate alphas as they used to do

when they found themselves in crowded trades.

The hedge fund industry that will emerge after the global economic downturn

will be likely characterized by a greater concentration of assets and lower levels

of leverage. With more closures and less launches the top 100 hedge funds

accounted for 75% of the total industry assets in 2008, up from 54% in 2003.

Additionally, the hedge fund industry may also be characterized by more

diversified strategies with less leverage.

Although it is posting positive results, the industry is not healed yet and it is still

important to remember and take into account the 2008 enormous crash. There

have been no clear macro trends during the first half of the year and hence there

is high uncertainty about where the economy is heading.

Among the positive aspects there is the fact that macroeconomic indicators

continue to improve, particularly in the USA and the emerging markets. When

looking at one of the key causes of the financial turmoil, the US housing market,

it seems that thing are recovering. According to HSBC, the US housing market is

showing signs of recovery. For instance, new home sales in the US climbed 11

percent month-on-month in June.

Governments and central banks have been effective in avoiding a severe and

prolonged economic slowdown, however the likely recovery that will happen in

the last months of 2009 and in 2010 will not be strong.

There are several reasons leading to this conclusion. First of all, governments

will be forced to release their stimulus measures in order to reduce the levels of

public debt and also to find a balance between aspirations of growth and threats

posed by potential inflation. Second, labor market conditions continue to

deteriorate and in some countries unemployment rate is expected to go well

above 10 percent. Being a lagging indicator, improvements in the job market will

not be immediate neither significant, thus negatively affecting consumer demand

and overall economy growth.

2.4 Performance of single strategies in 2009

Although 2009 has been favourable to hedge funds as an asset class, things are

different at the sub-category level. According to the Credit Suisse/Tremont

database, Convertible Arbitrage strategy, which performed negatively in 2008, is

up more than 35 percent since the beginning of the year, thus continuing to be the

best-performing hedge fund strategy this year followed by the strategies that

exploited emerging markets momentum. Other strategies which suffered a hard

hit to their reputations over the past years are experiencing a good period as well.

Many of the world’s largest funds have reported extremely high returns since

January 2009. The UK funds, GLG and Tosca, have started making their way

back after they were hit really hard last year and traditional strategies such as

equity long/short and arbitrage are regaining consensus among asset managers.

On the other hand, managed futures which was very strong last year is down

almost 7 percent. The worst-performing strategy so far this year is dedicated

short selling which suffered from the powerful rally in global equity markets and

was down on average more than 7 percent in July and 1.7 in August, reaching a -

18.68 percent since the beginning of the year.

To sum up, strategies that performed well in 2008 are now performing poorly

while the worst performing funds of last year are amongst the best performers in

2009. Credit Suisse/Tremont reports that eight of ten strategies posted positive

returns in August and are experiencing a positive performance year to date.

2.4.1 Convertible Arbitrage

Convertible arbitrage is currently the best performing strategy year-to-date. On

August it posted the eighth consecutive month of positive performance, thus

bringing the year to date return to 35.6 percent, amid a strong performance of

equity indices, healthier credit conditions and volatility going down.

The strategy is making its way back after a perfect storm in 2008, when the

forced sell-off by hedge funds in the convertible space, the extensive de-

leveraging and the ban imposed by governments on short-selling weakened

managers ability to realize profits and made Convertible Arbitrage strategy one

of the worst performers.

The convertible bond market seems to have overcome the steep drop in the fourth

quarter 2008 and demand by fund managers and other investors has increased

despite the fact that supply was somewhat constrained. In August 2009, we have

also witnessed a slowdown in new convertible bonds issuance, with respect to

previous months. However, it is expected that companies will turn to convertible

bonds between now and the end of the year as a source of cheaper financing in

the foreseeable future.

Interestingly, convertible bonds, which should trade at a premium with respect to

straight bonds with similar maturity issued by the same company because of the

value of the embedded equity option, suffered a severe devaluation in 2008 and

ended up being quite cheap at the beginning of the year. Indeed, cheapness levels

of convertibles were at all time highs at the end of 2008 and beginning of 2009,

so yields on some convertibles bettered those of the straight bonds.

Devaluation was mainly due to the sell-off by hedge funds operating in the space:

because the market for lower grade convertibles was disappeared, managers had

no choice but to sell higher quality assets in order to generate cash. Moreover,

convertibles’ value further decreased as equities kept on decrease in 2008: the

underlying share prices for many convertibles dropped below the strike price and

the embedded equity options ended up being out of the money.

The atypical yield advantage for many convertibles and the resumption of

primary market activity attracted non-traditional credit and equity investors to the

convertible space. These crossover investors played an important role in the first

part of 2009 because they have brought some liquidity back to the market.

The devaluation has been slow to correct as both hedge funds and crossover

investors have continued dealing with liquidity issues. As a consequence, new

issues were still priced attractively in March 2009 and convertibles remain

relatively cheap still today.

During the next months the attention of managers in the convertible bonds’ space

will likely be addressed to the credit long play aspect of convertibles with little or

no leverage, as opposed to volatility trading.

In fact, improving credit conditions usually lead to lower stocks’ volatility which

is bad for a long volatility strategy as that of convertible arbitrage whereas

narrower credit spreads lead to higher convertible bonds’ valuation which is good

for going long on credit.

2.4.2 Emerging Markets

The performance of the emerging markets managers is strictly linked to that of

underlying markets. Looking back at 2008, emerging market equities suffered

from severe losses as risk aversion rose. However, both equity markets and

currencies began to strengthen in December, thus leading to positive results for

managers investing in this space. Although global markets are still affected by

economic uncertainty, the MSCI Emerging Markets Index has outperformed the

S&P 500 and MSCI world index in the first part of 2009.

By looking at the performance of hedge funds in the space we can see that they

registered positive returns for six out of the first eight months in 2009, as

measured by the Credit Suisse/Tremont Index. In January and February they

were still affected by the negative performance of emerging market equities, as

measured by the MSCI Emerging Market Index. In the following months,

managers benefitted from the returning appetite for international risk on the back

of fiscal stimulus packages. In May, managers experienced the third consecutive

positive month. Optimism about growth was also supported by rising commodity

prices because many of Emerging economies are classified as exporters of

natural resources. Indeed, the S&P GSCI reported a monthly positive return of

almost 19.7 percent in May and is currently up 4.5 percent on year to date.

In August, emerging equity markets were down 0.5 percent as measured by the

MSCI Emerging Market Index, mostly driven by the negative contribution of

China. However, emerging markets managers were able register a positive

performance.

According to T. Rowe Price Research, emerging markets are now better placed

and stand in a much stronger structural position to deal with harder economic

times than in previous crises. Emerging markets outperformance versus

developed markets has been fuelled by many factors.

First of all, they had built up substantial foreign currency reserves that have been

used by many governments to adopt a proactive response to slower growth. They

have been effective in preventing defaults, currency devaluations and further

decrease in investors’ confidence, thus avoiding that a crisis which started from

the developed world could have translated into an even larger crisis in the

emerging world.

In other words, emerging market governments around the world have undertaken

effective monetary and fiscal policy responses in order to prevent the crisis from

deepening. Most obviously in China, where a $585bn stimulus package is

expected to drive its economy towards an estimated 8 percent GDP growth in

2009, according to Bloomberg estimates.

In essence, many emerging economies are in the enviable position of having both

the ability and the willingness to use domestic resources to stimulate domestic

demand and investments. On the other side, many developed nations are heavily

indebted and are expected to run in big deficits in order to launch stimulus plans.

The overall health of the emerging markets is also demonstrated by financials

sector which compares favorably with that of developed markets. In fact,

financial sector received great assistance by developed nations whereas it has

emerged relatively unscathed within the emerging nations. The main reason is

the relative simplicity of balance sheets and lower levels of overall leverage.

It is expected that when global economy will eventually recover, emerging

market growth will account for an increased share of global growth, perhaps as

much as two-thirds against less than 50% of the pre-recession period, as

estimated by T. Rowe Price Research.

Emerging markets will continue to provide a rich source of future returns for

hedge funds. However it will be critical to identify potential divergences among

different countries and regions. Such differences will be a permanent feature and

understanding them and the way in which they relate to both opportunity and

risk, will be crucial to effectively capture the benefits of the opportunities

presented.

2.4.3 Managed Futures

Managed Futures managers are performing negatively this year. During the first

two months of the year, gains were coming from short positions on equities and

agricultural commodities and from long positions on the US Dollar versus other

currencies. Such gains were partially offset by losses coming from short

positions on energy commodities, as major energy prices were going up during

the last weeks of February.

In March, managers posted negative returns as equities sharply reversed. Indeed,

managed futures suffer from trend reversal just as they benefit when trends

accelerate. Moreover, other losses came from long positions on the US Dollar

and bonds as both of them weakened, thus reversing the earlier trends.

During these months managers suffered from the lack of clear trends. In fact,

even if volatility was above the average it was not directional, so there was a

tremendously challenging environment for long-term trend followers.

In June and July trend followers have started to shift to long positions in

commodities and equities and posted positive returns in August. Investors gained

form long position in equity markets and commodities even though returns were

generally lower than in the previous month. In particular, commodity markets

experienced again significant divergence between various sectors: natural gas

prices declined while agricultural gained.

2.4.4 Fixed-Income Arbitrage

Institutional investors generally prefer riskier investments over fixed-income

hedge funds. Investments that have exposure to equities, commodities or also

alternative asset classes are highly demanded and usually dominate investors’

portfolios.

However, many investors preferred to abandon such strategies during the

economic crisis of 2008 and fly to quality in the attempt to preserve their wealth

by focusing on high-quality fixed-income funds.

Indeed, “government debt is considered one of the safest places to invest. In

times of financial market turmoil, short-term Treasury prices skyrocket, thus

lowering the yield. Government debt prices and yields move in opposite

directions.

In early December 2008, for example, the yield for the 3-month Treasury bill

bottomed out all the way to zero, indicating that investors were more concerned

with keeping their investments safe than making any kind of a profit.”14

Investors became interested in fixed-income strategies because bond markets

were considered to be a more stable environment. They were looking not only at

safety but they were also interested in adding exposure to their portfolios in order

to beat equities. Not surprisingly, there was an increasing interest for fixed-

income hedge funds.

Fixed Income strategy was the third top performer for 2009, according To Credit

Suisse/Tremont data provider. Most of the arbitrage strategies in the previous

months were designed to exploit movements in the yield curve, coming from

central banks’ announcements of buy-back programs and from announcements of

governments of new issuance of securities to finance their debt.

14 Clifford C. (2009), Green shoots? Check the yield curve, CNNMoney.com, May

In the US, the Federal Reserve has kept its key rate low since December 2008, at

a target range going from 0 to 0.25 percent in the attempt to stoke capital lending

and spur the economy.

Since the Fed put all of its effort to keep interest rates low, the front end of the

yield curve, including the 2-year note, has been locked. The reason is that the

shorter term Treasury yields are tied closely to the Federal Reserve's key lending

rate. It goes without saying that much of the spread's movement has been led by

the 10-year note yield, which was just over 2 percent in mid-December but rose

above 3 percent in May 2009.

When looking at the last quarter of 2008, it is clear that investors were feared by

the fact that major financial institutions were experiencing hard times while Wall

Street was crumbling. Investors flew to safety, selling everything but shorter

terms treasury bonds. As a consequence the longer end of the yield curve

experienced an excess of supply and yields increased.

In February 2009 the situation was similar: the macro-environment was

characterized by weak economic data, which is usually supportive for fixed-

income products, especially shorter-term government bonds. However, the rising

supply of government bonds to fund stimulus programs more than offset the

pressure posed by demand and bonds cheapened in the longer end of the yield

curve. The government unveiled unprecedented spending initiatives to prop up

financial institutions and restore investor confidence and so it had to bring a

record amount of new issuance to market in order to pay for the various stimulus

programs. The sheer volume of supply has put downward pressure on bond

prices, sending yields higher. Fixed-Income Arbitrage managers were able to

benefit from such supply-induced distortions, using curve and volatility related

strategies.

In March 2009 there were other opportunities related to moves in the longer end

of the yield curve as UK, US and Japanese governments announced to start their

Quantitative Easing policy. Governments were worried about sinking Treasury

prices and rapidly rising yields, and in order to stabilize the situation the

government entered into a program of quantitative easing, consisting in buying

back its own debt.

Central banks started to buy back 10 year treasury securities in order to keep

longer term rates low. For instance, the 10-Year US Treasury yield reached a

level of 2.5 percent but ended the month at 2.7 percent as there were several

auctions of new issuances. The Fed announced it was going to buy $300bn of

long-term treasury bonds through August in order to stimulate demand.

Overall, quantitative easers were successful in limiting the steepening of the

yield curve, also climbing due to concerns over long-term inflation, but not in

obtaining a flattening. Even though there were buy-back programs pushing the

prices up and the longer end rates down, the size of the new issuances were such

that the supply of debt flooded the market and sent long-term bond yields higher.

Indeed, May and July were still characterized by a global sell-off in the longer

end, and consequently curve-steepening.

When the spread between the 2-year and the 10-year bond yields widens, it

usually signals that the economy is recovering. Short-term interest rates are

depressed because of the economic downturn but long-term rates are high in the

expectation of a growing economic activity and a future high demand for capital.

However this is not the case in the current economic situation. Yield curve is

steep not because of the expectation of an immediate recovery but most likely

because governments are running huge amounts of debt, have continue to issue

long term bonds during the past year and borrowing costs have increased.

Another explanation for a steepening curve is the expectation for inflation which

pressure the prices of longer maturity treasury notes. However, inflation should

have affected also inflation protected bonds (TIPS) whereas this market has been

relatively steady.

The spread experienced in the recent past has more complex factors widening it

than in other periods of economic slowdown.

Fixed Income managers were able to generate positive returns and benefit by

participating both to the underwriting processes of government bonds and, on the

other side, from buy-back programs by central banks. Many Fixed Income

managers anticipated a choppier environment for some time, so they prepared for

these moves by keeping low exposures to the longer end.

CHAPTER 3 3.1: Regulation; 3.1.1: The EU; 3.1.2: The UK; 3.1.3: The USA; 3.2: Better Corporate Governance?; 3.3:

Risk Management?; 3.4: Transparency and Due Diligence; 3.5: Fees; 3.6: Industry Consolidation;

The hedge fund industry has not been immune to financial market dislocations:

many hedge funds have wavered, some have even performed well but the

majority of them have gone out of business. Overall, investors have lost

confidence and risk appetite in the asset class.

While governments worldwide are still busy trying to tackle the severe crisis that

crippled financial markets, hedge funds have started to register comforting

performance and started to experience a slow down in asset outflows.

However, they now face a new challenge, coming from regulators. It goes

without saying that, after the events of the past 18 months, many things will

change in the future and the hedge fund industry will not be immune. Managers

are currently concerned about the impact that recent events will have on their

business and on the environment in which they work.

The general opinion is that we have assisted to years of excessive deregulation

and now we are called to regulate the unregulated. As a consequence, both

investors and alternative asset managers will face a new environment,

characterized by a more sophisticated and robust infrastructure. Structural

changes will shape the future of the hedge fund industry and, most importantly,

the way in which hedge funds will organize their business and trading activity

will be at least as important as how well they perform.

In this chapter I will try to discuss some key issues and analyze some of the

likely changes that will characterize the near future of the hedge fund industry.

3.1 Regulation

The recent experience has taught that any single financial institution, bank,

insurer or fund may pose systemic risk to global financial markets. As such, an

unregulated hedge fund industry has the potential to threaten the markets and

magnify the extent of a crisis.

Indeed, hedge funds are very active and leveraged market players, thus have the

potential to create a relevant impact on markets. Until now, they have been able

to build up massive leveraged positions and to take excessive risks. Moreover,

they are no longer a little niche industry for sophisticated investors and in the last

three years they did contribute to magnify market movements as a result of

deleveraging and investor redemptions.

According to Andrew Donohue, SEC director, hedge funds account for 18 – 22

percent of the total trading on the New York Stock Exchange but the SEC has at

its disposal only incomplete and unreliable data, hence cannot exercise a proper

oversight.

However, hedge funds bring also some benefits to the markets. Namely, they

have an increasingly important role in current capital markets both as a source of

capital and as an investment vehicle for institutional and high net worth

investors. They also provide liquidity and possibilities of portfolio

diversification.

Before the current crisis, the industry has reported several years of growth but

needs to adjust and refine now in order to regain strength and stability so to

attract again less confident investors and earn the community consensus.

It will not be sufficient anymore to show historical track records or outstanding

skills or rely on reputation because investors have learnt the lesson and will be

more rigorous in conducting their due diligence and fund selection processes.

The current crisis has led to the conclusion that standards and conventions

adopted in the past may not be accepted in the future and hedge funds will have

to adapt if they want to attract investors and perform well. In particular, hedge

fund managers must move quickly towards newly proposed rules in order to

check and understand to which extent and how they will affect their business and

operating model. Although new rules are not definitive, managers should monitor

developments carefully as new rules emerge.

Effective Risk Management, adequate corporate governance, transparency and

independency will be critic factors for the comeback of the industry. In addition

to that, managers will not earn large fees anymore.

It is clear that the legislative action will strengthen regulation and will likely lead

to mandatory oversight and regulatory requirements for the hedge fund industry.

The result is that after 20 or 30 years in which the hedge fund industry has been

able to obtain a light regulation it is now trying to prevent over-regulation.

Although it is still unpredictable whether hedge funds will be required to register

with national commissions such as the SEC or subject to the oversight of central

banks, they will have to face more stringent rules for sure and reconsider the way

they manage their business and disclose the relative risks. Most likely, hedge

funds will have to adapt to the best practice standards and demonstrate robust

controls and processes.

The more rigorous regulation will have several advantages and all of them will

have the effect of enforcing a stronger investor protection:

• First of all there will more information about the hedge fund industry at

disposal. The more accurate, reliable and complete data about hedge funds’

teams, business, clients will give the chance to estimate the threats of creating

risk for the market integrity.

Such data will be available thanks to periodic inspections and examinations and

also thanks to books and records that hedge funds will likely be required to

maintain.

• It will enforce fiduciary responsibilities and support existing anti-fraud

provisions by creating a deterrent effect. In particular, registration will increase

the chances of identifying and discovering misbehaviors, fraudulent activity or

conflicts of interests, when the manager has not properly disclosed them. Lastly,

compliance programs will help managers to manage their conflict of interests.

• It will also allow to impose, when necessary, investment restrictions and

diversification requirements in order to protect investors or regulate redemption

suspension terms.

• Mandatory registration could allow to identify persons unfit to manage a

hedge fund and so deny the permits.

Among the disadvantages of a tighter regulation there is the fact that hedge funds

will inevitably lose some of their flexibility to invest in accordance with

opportunities. Regulation represents without a doubt a threat for hedge funds

because it will create further costs while decreasing leverage and the overall

ability to pursue investment strategy. The question is whether managers will still

be able to generate the needed returns or will have to face over-regulation.

Moreover, disclosure about hedge funds’ investment strategy, asset positions,

and trades can facilitate imitation by others market players, which likely leads to

deterioration in the hedge fund’s performance. In particular, hedge fund

managers are concerned about how their trade secrets will be safeguarded. So

even though lack of transparency of hedge funds undoubtedly magnifies financial

crises due to counterparty concerns, disclosure will add a cost to hedge fund

strategy.

There should be a balance between regulation and flexibility of the universe of

alternative investments, so to obtain the twin goals of higher protection for

investors and for financial markets on the one hand and maintain the benefits

coming from the hedge fund industry on the other hand.

3.1.1 The EU

The European Commission published a draft directive at the end of April 2009,

which is proposed to apply to Alternative Investment Fund Managers established

in an EU member state and which provide their services to one or more

alternative investment funds, that is, hedge funds or funds of hedge funds.

Moreover, the directive is also addressed to managers established outside the EU

that are marketing their fund within the EU. This means that the directive will

apply to EU and non-EU fund managers that offer or place units of shares in their

fund to EU investors. It does not matter whether the offering is solicited or

unsolicited, hence if the non-EU manager responds to an unsolicited approach

from a EU investor he is subject to the directive.

The directive is a response to the financial crisis and is aimed to enhance

transparency while reducing potential systemic risk that hedge funds can pose to

the economy. Among the others, it provides for leverage limits and for an

independent valuation agent to value the fund’s assets at least once a year. It will

also increase the degree of harmonization by eliminating differences between

national laws.

The European Commission stated that its intention is to finalize the Directive by

the end of 2009, so that it will come into force before the half of 2011. Even

though the directive is currently at the beginning of the EU legislative process

and will likely undergo several amendments, the general opinion among experts

is that most of it will remain in the final version.

As of today, the EU draft directive is quite stringent and imposes a mandatory

registration for managers and funds. It requires that they disclose the level of

leverage employed, to both investors and regulators. It also requires the

appointment of an independent valuator so to have a sound valuation of the

fund’s assets.

What drew the attention is that the directive is particularly restrictive for non-EU

managers as there are several provisions and limiting conditions that apply to

them. If non-EU managers will not satisfy such conditions they will be denied to

market their funds within the EU.

As an example, non-EU managers must be established in a country that has a

legislation on regulation and supervision which is equivalent to that of the EU

directive. So, if a US manager wants to market a (EU or non-EU) fund in Italy he

will obtain the necessary registration only if there is equivalence between US and

EU legislation, especially on tax matters. Moreover, if a EU manager wants to

market a Cayman (non-EU) fund there should be equivalence between EU and

Cayman legislations, that is very unlikely.

Fund managers will also need to appoint a EU-domiciled depository. Hence,

depositories must be credit institutions with registered offices in the EU.

It goes without saying that if the final directive will keep all these stringent

conditions, EU institutional and wealth investors will likely be restricted in the

choice of funds in which they can invest. They will not have access to a

significant portion of alternative investment funds.

3.1.2 The UK

Some of the provisions introduced by the European Commission directive are

already industry practice in the UK, such as those aimed to increase transparency

and disclosure or remuneration policy. However, the UK industry is greatly

concerned about the potential restriction on trading that the EU directive will

create. Indeed, even though the UK regulator, the Financial Services Authority

(FSA), agrees on the fact that more rigorous regulation should be considered,

there are several critics addressed to the EU directive.

First of all, the limits on the use of leverage in excess of the fund equity capital

implemented by either a putting a cap or an average level during a given period,

are seen as too strict. The UK would prefer higher supervision and data reporting

instead of such limitations.

Another important critic has been addressed to the provisions that limit the

ability of European investors to access to non-EU funds, thus affecting their

possibility to invest internationally. According to the UK the directive

unnecessarily restricts both non-EU managers operating in the EU and EU

managers marketing foreign funds.

In addition, the UK regulator disagrees on the provision regarding the need of a

EU depository. As of today, the EU directive states that managers aiming to

market their fund within the EU must appoint a EU-domiciled depository.

According to the FSA such provision will create a de-facto monopoly of EU

credit institutions, thus disadvantaging non-EU banks such as US and Swiss

based providers.

The UK government will probably lobby for obtaining amendments to the

current provisions of the directive, thus avoiding the risk of over-regulation.

Moreover, it will try to ensure a cohesive approach with respective to the US

legislation in order to obtain communication among regulatory bodies and avoid

geographical fragmentation.

To be noted that almost 85 percent of EU hedge funds managers are based in the

UK so the observation and critics of the UK regulator are worth being

considered.

3.1.3 The USA

The USA seems to be moving at a slower pace than EU but they are still moving

in the same direction. In June, the Obama administration recommended in its

Administration Proposal on regulatory reform that hedge fund managers should

register with SEC. Then, in July, the US Senate Banking Subcommittee on

Securities discussed about the possible ways to improve the oversight on hedge

funds and other private funds. The SEC also agrees on the necessity of closing

the regulatory gap and complains about the fact that until now it has the

possibility of seeing only a slice of the private fund industry.

If approved, the Private Fund Transparency Act of 2009 would require that hedge

fund advisers, as well as all private fund advisers, must register to the SEC, under

the existing Advisers Act, if they have at least $30m of assets under

management. In particular the mandatory registration requirement would be

extended not only to US investment advisers but also to all non-US investment

advisers who have US clients. The SEC would have full authority over all private

fund managers meeting such term.

By this way, the SEC would have the needed information about the industry to

adequately protect investors and the security markets. Moreover, it is likely that

hedge funds themselves, in addition to their advisers, will also have to register

under the existing Company Act. By this way the SEC expect to have the power

of inspection of hedge funds and could obtain complete data about the industry

so to reach the goals of enhance transparency and enhanced protection of

investors and capital markets.

On the other side, even though hedge funds and the broader private investment

industry recognize that there should be regulatory requirements to protect

investors and counterparties, they think that the regulators should introduce a

different law or statute for private investment funds, such as a Private Investment

Company Act, tailored to their specific and unique characteristics.

In fact, there is the risk that the Advisers and Investment Company Acts could be

inadequate and too much restrictive for hedge funds. The greatest concern for

hedge funds is that these existing acts are designed for advisers and funds which

are addressed to retail investors and could be not appropriate for funds addressed

to institutional and wealthy investors.

Simply extending those Acts to the hedge fund industry could prove

unsatisfactory because they do not have the right provisions suited to face the

types of risks posed by hedge funds, their investment structures, strategies and

the type of contracts they enter.

The Advisers and Investment Company Acts are designed to protect a large

number of retail investors and they could end up offering an inadequate

protection to selected groups of institutional and high net worth investors.

As an example, the Investment Company Act provides for either daily liquidity

(mutual funds) or no liquidity terms (closed-end funds), whereas hedge funds

adopt a flexible approach, with flexible redemption dates.

In conclusion, even if the Congress will choose not to develop a separate Act but

to extend the existing Acts, it should write a set of rules that are tailored to hedge

funds. Such rules should provide targeted controls needed for oversight of hedge

funds while allowing them to preserve their flexibility. In particular, there should

be more detailed provisions for the largest funds as they have a greater potential

to magnify systemic risk.

As of today, enhanced Advisers and Investment Company Acts appear to be the

most effective and smartest approach to regulate hedge funds. The SEC, which is

the current regulator with oversight powers, will likely have an extended

regulatory mandate and control responsibilities. However there are concerns

about whether the SEC will have the needed resources and capabilities to be an

effective regulator when hedge funds’ managers and other private pools’ advisers

will be required to register under an extended registration framework. It goes

without saying that the SEC will need new tools and resources along with greater

authority.

3.2 Better Corporate Governance?

Although regulations governing the hedge funds vary across different countries,

overall they are loosely regulated and they are free to employ various techniques

and instruments to execute their investment strategies. In the USA, there is no

corporate governance at all, hedge funds are not subject to any agency which has

the mandatory power of inspection and control over their activities. They are

only subject to various anti-fraud rules.

However, if the activities of hedge funds will be under increased scrutiny, they

will need better corporate governance as it represents one of their weakest points

right now. Hedge funds will be required to demonstrate that they have a sound

governance structure, allowing to clarify how decisions are made as well as

control structures that allow to adequately manage several types or risks such as

investment, operational and credit ones.

• As an immediate priority, hedge funds probably need a board, made up of

active, independent and loyal members, which can ensure an effective and

genuine control over the valuation process of the fund’s positions. The board

should be active in evaluating the pricing process and in challenging the

valuations of the fund when necessary.

Valuation of assets will likely be one of the main areas of regulatory focus

because it is critical to assess the position of the fund. Today, hedge fund

valuations are typically performed internally by managers and not by

independent external administrators. This means that valuations could lack in

accountability or transparency while leaving room for mispricing. On the other

side, investors have become more insistent about transparency and more

sophisticated.

Indeed, hedge funds make use of several financial instruments, some of which

are not traded on centralized exchanges and hence appropriate pricing becomes a

very difficult task. In addition, they make investments such as illiquid distressed

debt which are hard to value because of their nature.

Hedge funds also rely on fair valuation methodologies, which are different from

fund to fund as they require great amounts of personal judgment and discretion.

The board could be helped by valuation committees in overseeing the various

aspects of the business but the legislative action appears to be addressed towards

a third-party administrator. As of today, administrators tend to accept managers’

valuations when they come to that part of the portfolio which is unavoidably hard

to value. However, this portion is the most challenging and investors need the

most independent and objective oversight.

Instead of simple verification and confirmation functions, administration

companies should have a valuation and price origination function, thereby

providing a mechanism to prevent potential frauds.

• Since hedge funds have recently imposed gates and lock-up periods, investors

may also require that an independent board exercise a genuine oversight over the

decisions of the fund to suspend redemptions. In particular it should take an

independent decision whether a redemption suspension is necessary in order to

protect the fund’s portfolio value or not.

• A solid corporate governance should also provide a division of

responsibilities in order to avoid concentration of power and potential conflict of

interests while guaranteeing a balance. Corporate governance should ensure the

possibility of having free challenge.

Corporate Governance is strictly related to effective Risk Management

procedures as it creates the bases for appropriate evaluation and control of the

risks associated to alternative asset management.

3.3 Risk Management?

Risk Management is becoming increasingly important and is gaining

unprecedented attention from hedge fund managers as they feel that it has

become an almost non-negotiable prerequisite to attract resources. Indeed,

managers agree that this area will undergo significant changes in the near future

as investment and operational risks are rising significantly and the marked

volatility of financial markets is magnifying the concern of both investors and

regulators.

It goes without saying that nowadays it is far more difficult than ever to achieve

effective protection against markets turbulence. According to Moody’s,

deficiencies in operational management and control accounted for a relevant

portion of the losses suffered by hedge funds last year. Many conventional

approaches have failed and so an effective handling of risk issues has been

demonstrated to be imperative.

As an example, hedge funds used to rely on Value at Risk measurements in the

past, which shows the kind of loss that can happen 95 or 99 times out of 100.

However, the current crisis has highlighted the limitations of such a method

because what really matters is what happens in the tail, in the extreme event or

else, in the bad months of the year.

Investors require today more detailed information about the risks surrounding the

hedge fund industry and thus perform a careful scrutiny of this function. In

particular, when conducting their due diligence investors are now more than ever

interested in having information about how risk management is carried out. Risk

management is probably the first step to regain investors’ trust.

Another important factor that is contributing to make risk management a more

relevant topic than ever before is the need to respond to regulators. Indeed,

regulators worldwide are paying more attention because sound risk management

will contribute to prevent future financial dislocations. At the same time, the fact

that there will be new rules regarding risk management, is also creating

confusion within the hedge fund industry.

Lastly, managers are devoting a larger share of resources to risk management not

only to respond to investors and regulatory concerns, but also to develop new

approaches. Indeed, the critical risks that funds are facing today are moving

beyond the traditional investment and operational risks. The current crisis has

highlighted new areas of risk and so it calls for more complete risk management

processes. For instance, avoiding reputational damage is one of the most

challenging concerns today. Hedge funds have to take into account also liquidity

related issues, fiduciary and counter-party risks.

These considerations imply that risk management should be a comprehensive

tool addressing all risk types, traditional as well as new-brand issues, while

enhancing an appropriate information flow, thus increasing the level of

accountability of the overall function and eliminating potential gaps across

different areas of risk.

To sum up, investing in risk management seems vital in a volatile and

unpredictable environment where many funds have succumbed. An appropriate

rethink of risk management procedures across the industry is thus necessary.

• Managers should implement sound processes aimed to assess the

investment risks related to the specific strategies employed. At the same time,

they need to control operations and enforce a dialogue between the investment

staff and the rest of the firm.

• Moreover, the financial crisis has highlighted that hedge funds face a

relevant amount of counter-party risk, especially the risk that their prime broker

can collapse. In order to reduce such risk, many hedge funds have started to

maintain multiple prime brokerage relationships, thus increasing diversification

and in turn reducing the dependence on every single commercial relationship.

Managers will have to undertake counter-party risk assessments and monitor

their prime broker relationships closer than ever. Moreover, they should develop

a contingency plan addressing the risk that a major broker will disappear.

• Another important risk is represented by liquidity: when they receive large

requests of redemptions hedge funds can use existing cash on hand but then are

likely forced to sell their assets. Using cash reduces the ability of funds to

employ capital and exploit new opportunities in the pipeline, thus creating an

opportunity cost for managers and remaining investors. Moreover, selling quality

assets to meet redemption requests of short-term investors will leave long-term

investors with a pool of illiquid assets.

While fund managers should not deprive investors of the possibility to access to

liquidity, managers should properly use gates and lock-ups to smooth redemption

pressure over the long term to avoid mismatches between investment and

redemption horizons and to ensure that liquidity risk will not be faced

exclusively by long-term investors

Managers must be sure that liquidity terms are shorter than redemption periods

so to have plenty of time to raise the sufficient cash to repay investors. However,

the opposite was true during 2008 when hedge funds were forced to heavily rely

on redemption suspensions and longer notices.

Such situation led investors to be more concerned with funds’ liquidity

structures. Indeed, the general opinion is that funds should increase and

constantly monitor the level of liquidity of their portfolios in order to identify

weaknesses and better manage liquidity crisis. They should also conduct liquidity

stress tests aimed to indentify mismatches between liquidity terms of the fund

assets, that is the time needed to liquidate them, and redemption terms.

• Nowadays, the greatest current concern for the hedge fund industry is

probably reputation. As managers are striving to regain consensus among

investors they recognize that reputational risk is hard to define and quantify,

hence to manage. It represents an area where risk management needs to develop

appropriate procedures.

• In light of the current EU directive, jurisdiction is now a significant

component of risk. Fund managers need proper expertise to deal with challenges

posed by cross-border investments and by the marketing of their fund across

different countries.

3.4 Transparency and Due Diligence

The hedge fund industry has witnessed several failures over its history. LTCM,

Quantum and Tiger funds are all examples of funds that collapsed because they

had experienced strategy-led problems. Indeed, the managers were overly

optimistic and probably too much arrogant.

The current crisis instead has been characterized by extreme drawdowns in the

major markets, thus leading many managers to shut down their fund. This,

combined with recent cases of fraud like Madoff’s one, has spurred investors to

conduct more detailed and intensive researches of the fund before committing

their money.

Such events have caused the balance of power to shift from managers to

investors. Since hedge funds have demonstrated to be not immune to large

drawdowns, investors increasingly ask for more courtesy and transparency to

check whether managers have set up strong and robust infrastructures to face this

climate.

The reason for enhanced transparency is that it is necessary to manage in a

proper way the systemic risk that hedge funds can potentially create. However, it

is unclear whether such disclosure will be publicly available or will be available

on a confidential basis to the regulators of the industry.

Investors now require more transparency, more information on a more constant

basis because they want to make sure that their money are handed properly and

they want to see appropriate controls in place to prevent fraud and

misbehaviours.

They want to take a closer look at internal operations, exposure monitoring and

crisis recovery. In addition, they want more details on positions, valuation

procedures and fund’s administrator and other counterparties the fund is using.

Investors also require more transparency about how the fund pays compensation

to managers and general partners. This point is very delicate right now as hedge

fund managers have been attributed the bad reputation of being selfish,

concerned to enrich themselves at the expense of investors. All these issues

represents key steps in today due diligence processes.

From a fund manager’s perspective, this change in investors’ due diligence has to

lead necessarily to a shift in emphasis. Before managers were exclusively

concerned on performance numbers, believing that if returns were strong

everything else would look strong as well. Today, they need to care not only to

front office investment strategies but to back office aspects as well.

In order to attract investors’ interests, managers must prepare more detailed

offering documents, with unambiguous terms, especially about restrictions and

specific disclosures. They have to provide more information on the type and

amounts of assets that they hold and must clarify how decisions are taken and

things are monitored because investors view this transparency as a competitive

advantage of the best hedge funds. Offering documents cannot be in favour of

managers and at the expense of investors anymore. As of today, investors want to

make sure that managers do not have an unrestricted freedom of action.

3.5 Fees

With hedge fund industry reporting poor results in 2008, investors have become

more concerned with the fees they pay to managers. In particular, investors are

upset with the recent performance and have started to think that the hedge funds’

fee structure is way too expensive. Even though investors do not pay any

performance fee when the fund performance goes below the high-water mark,

high management fees are not justified by last year losses, increased risk and

reduced possibilities of redemption.

First of all, management fees should be used by managers just to cover operating

expenses and not for strategy expansion or business reinvestment.

Coming to performance fees, investors think that they should be calculated on

alpha and not on all positive returns above the high-water mark level because the

hedge fund industry is about alpha generation.

Secondly, performance fees should not be calculated on a yearly basis but on a

period that is at least equal to the period for which investors’ money are

committed. In other words, there should be an alignment of performance fees

with realisations for investors over an extended period of several years. Indeed, if

money cannot be redeemed before than a lock-up period of three years, managers

should not receive any incentive fee until the three years have passed because

this will be the first opportunity for investors to decide whether to withdraw or

retain money to the fund.

Several pension funds have proposed plans to hedge funds with their preferred

terms. They agree on the fact that fees should be paid at the end of a lock-up

period or spread out over several years instead of being paid on a yearly basis.

Another critic which has been addressed to the fee structure is related to the fact

that incentive fees are calculated on the Net Asset Value (NAV) of the fund,

which is derived from single assets’ evaluation. Such evaluation is not a problem

for securities that are traded on global exchanges with readily available prices.

However, things are different for complex and hard-to-value instruments as the

evaluation of such securities is often subjective and funds’ administrators usually

execute a mere confirmation function. The problem is magnified by the fact that

managers run into a conflict of interest when they have to evaluate assets that

will contribute to the overall NAV of the fund because they will receive a 20

percent on positive performance.

The general opinion is that the 20 percent fee should be calculated not on NAV

but on realized prices at disposal. By this way, fees paid by investors would rely

on estimated and hypothetical values anymore. This is extremely important

because of the presence of hard-to-value instruments. Moreover, there would be a

reduction of potential valuation fraud by the fund manager.

Actually, some funds have slashed management fees last year in order to mitigate

the bad sentiment raising among investors because of poor performance and

lock-up periods. In addition to that, hedge funds on average are not receiving any

performance fee since the end of 2007 because of the high-water mark

mechanism. Indeed, on an industry index basis, the NAV peaked in the last

quarter 2007 and managers, on average, are still far from the old high-water

mark. Moreover, many hedge funds have offered to reduce performance fees or

fee breaks for next years on new capital subscriptions.

The main question is whether the 2 – 20 percent fee structure will remain or not.

Actually it depends on the balance between demand by investors and supply by

funds. Such balance has been in favour of investors last year, that is more supply

than demand, and fees have slightly become lower. However, the balance has

become more even this year as proved by the first net inflows during the first half

of 2009.

Chart 3.1: Average hedge fund fees by location Management Fee Performance Fee North America 1.54% 16.33% Europe 1.72% 17.94% Asia 1.55% 15.88% RoW 1.67% 19.25%

Source: Preqin

The information provider Preqin has surveyed fund managers in April and May

over the fees they asked to investors. The survey shows that fees were actually

lower than the traditional 2 – 20 scheme. Chart 3.1 shows that US fund managers

ask the lowest fees, probably because the US market is the most mature in terms

of supply and number of hedge funds.

However, it is likely that fees will go up again when the balance between demand

and supply will turn in favour of hedge funds.

3.6 Industry Consolidation

As we have seen, the new environment for hedge funds will likely be

characterized by rising costs due to the more stringent regulation, to the need for

more transparency and more robust risk management processes. At the same

time, investors are not willing anymore to pay expensive fees. These issues lead

to the question of whether the hedge fund industry will be characterized by fewer

but bigger funds, thus becoming more consolidated.

Indeed, managers will need a stronger capital base to give investors confidence

about the stability of the fund. Moreover, they will be pushed to increase the size

of their fund in order to increase revenues.

It goes without saying that in the new hedge fund industry it will be extremely

difficult for small funds to attract money and survive. It will be even more

difficult for new start-ups to face the barriers to entry represented by the

increasing costs.

On the other side, the hedge fund marketplace will become stronger as a result of

the ongoing turmoil and funds natural selection process. It is also true that fewer

managers and less assets will be able to profit from the opportunities rising in the

markets.

CHAPTER 4 4.1: What Distressed Debt Strategy is about; 4.2: Current opportunities; 4.2.1: European distressed debt

managers; 4.2.2: North American distressed debt managers; 4.3: Default rates;

After a period in which credit was seemingly available everywhere and to

anyone, where defaults rates were somewhere near zero and distressed debt

investors had no opportunities to invest, corporate defaults recently soared to

levels higher than at any point in the recent history, distressed debt began to be

available and companies started to go bankrupt. Global credit markets were

paralysed in the late summer of 2008 and the financial turmoil quickly spilled

over to real economy by October.

Today, the world of distressed debt securities and companies involved in

bankruptcy or restructuring is without any doubt full of opportunities for hedge

funds. However, one should bear in mind that no profits come without risk.

Distressed debt is an extremely risky investment area and not all distressed

companies are worthy to invest in. In order to enjoy the benefits of what could be

one of the greatest distressed cycles in history, investors must pay attention and

be diligent in their assets purchase process because selection will be

fundamental. Additionally, investors have to consider that such investment

strategy is characterized by a time horizon going from 3 to 5 years.

4.1 What Distressed Debt Strategy is about

Distressed debt investment strategy consists in constructing a position in a

company or securities which are experiencing financial difficulties. Such

companies may be in their bankruptcy reorganization or will emerge from

bankruptcy in the near future or just about to declare bankruptcy.

There are several reasons that could lead a company to distress: mismanagement,

overexpansion, product liability are just some of them. Perhaps the company has

short-term liquidity problems and is too leveraged to not file for bankruptcy

protection. As an example, many times a profitable business suffers from

cyclicality and is not able to generate adequate cash flows to make debt

repayments on a regular basis. Profitable business may also experience troubles

because of excessive leverage taken as a result of M&A activity or a leveraged

buyout. Lastly, it may turn out that a business have operational problems because

the product line is obsolete or competition has intensified.

It goes without saying that the most attractive opportunities for managers in the

distressed debt space are represented by firms with financial and not operational

problems because once the financial structure has been fixed up the company can

rely on its brand, market niche, industry position or products in order to go back

to profitability.

It is also worth to remember that distressed investment strategy is only about debt

markets, not equity. Indeed, it is rarely a good idea to buy stocks in a company in

distress, that has recently filed or is going to file for bankruptcy. The reason is

that stockholders would have the last claim in the liquidation process, when it

comes to divide the assets of a bankrupt company, and even when the company

successfully re-emerge from a restructuring proceeding there will not be much

value left for pre-bankruptcy shareholders.

By buying debt securities at a low price instead, one can take control of a

company that is performing poorly and is near bankruptcy. The aim is to become

a major creditor so to have a considerable power during the liquidation or

reorganization process.

Hedge funds usually start accumulating near-default or defaulted bonds, bank

debt and trade claims at deep discount to face value, due to difficulties of the

company. Then, they resell them in the short run for a profit, when the

restructuring proceeding has driven the price upward. Moreover, in a worst-case

scenario, the manager could realize a profit if the company is liquidated,

provided that the manager had bought senior debt in the company for less than its

liquidation value, because owners of debt have priority over equity holders.

Additionally, some managers have developed specific competences in

restructuring and bankruptcy proceedings, hence they invest in distressed debt in

order to go through the entire restructuring process, in the belief that the

company will successfully reorganize and leveraging on its operational stability

will return to profitability. Managers provide direction and support to the

management which may be inexperienced in bankruptcy situations, thus

increasing the chances of success. When upon emergence from bankruptcy

bondholders’ claims are turned into the new company’s equity, they acquire a

long-term control over the new company.

Hedge funds can access to distressed debt through several channels. First of all

there is the bond market which is probably the easiest way. Usually a large

supply of distressed debt securities is available on the market after a firm defaults

because other regulated funds such as mutual funds are not allowed to hold

securities that have defaulted.

Hedge funds can also buy distressed securities directly from mutual funds. By

this way they can ensure large quantities of securities in single transactions

without affecting market prices.

Lastly, hedge funds can extend credit to the distressed firm, which is usually in

need of cash.

4.2 Current Opportunities

The current volatile economic environment offers extraordinary opportunities in

the credit world and in distressed debt market, for many years to come. Indeed,

even though the current tightening of liquidity may represent a bad scenario for

some investors, others are positioning themselves and wait to capture a whole

range of distressed debt opportunities.

Scarce liquidity combined with extremely high corporate leverage and a slow

recovery of earnings will likely lead an unprecedented amount of businesses,

particularly those taken private through leveraged buyouts, to restructure their

balance sheets. The number of distressed businesses is still rising and many agree

on the fact that this will be one of the biggest distressed debt cycle ever.

In particular, hedge funds are shifting their attention to distressed debt investing

as money flows into high-yield bond funds, i.e. funds investing in bonds with a

higher risk of default or other adverse credit events, have increased in a time

where other strategies were registering negative flows. According to the data

provider EPFR Global, money flows into high-yield bond funds reached a net

$4.4 billion between the end of 2008 and early February 2009.

Even though there is a huge buying opportunity in distressed debt, managers are

still uncertain about when the market will bottom. In particular, there is concern

on the timing because of the risk of picking debt securities too early, when the

selling pressure can push the prices further down. Additionally, managers are still

reluctant to increase their allocations to distressed assets because of the flight to

quality recently experienced in the global markets. Another reason can be that

investors usually beware the front of the cycle because the first companies to file

for bankruptcy are empirically the worst ones.

Managers in the space are aware that early players may be burned as default rates

could still rise, thus threatening to deflate their debt portfolios. In particular,

managers are not sure right now that corporate defaults have hit the highest level

yet because the bankruptcy cycle could still be in its early stages. As a

consequence, there is uncertainty about when to enter the market.

Indeed, the richest pickings follow the period in which default rates peak and

funds that build their exposure by buying assets at too high price may found

themselves in troubles and miss their targeted returns. In fact, a Research by

Edward Altman at New York University’s Stern Business School confirms that

the two best years for distressed investing—1991 and 2003—followed the

peaking of high-yield bond default rates.

Investors that entered the market in the last part of last year evidently suffered

from losses as the Credit Suisse/Tremont Index reported an annual loss of –

20.48% in 2008 for the distressed debt sub-strategy. The index was down in the

first quarter of 2009 as well but then started posting positive performance.

Distressed debt investors think that the strategy hit the bottom at the end of 2008

and are now positioning to catch the rebound.

Indeed, many experts expect that prices will keep on going down and become

more attractive. In particular they agree on the fact that distressed securities

could keep falling until the first or second quarter of 2010. This is extremely

important because investors aiming to build their exposure into discounted

corporate debt, as any other investor, want to buy low and sell high. Hence they

will likely wait until the bottoming out in the second quarter of 2010, having

clear that they still face high levels of risk.

Investments in distressed securities are cyclical in nature, with the main part of

the cyclical aspect being the growth of distressed securities supply due to a

combination of fundamental and macroeconomic factors. It goes without saying

that investors must be opportunistic in timing their investments.

Going more in depth, the current financial markets offer several opportunities

across the capital structure. In the first phase of the cycle, hedge fund managers

frequently focus on bank loan opportunities and stressed high yield investments.

So, hedge funds are expected to initially invest in securities which are higher in

the capital structure of a distressed company so to have a better collateral and a

stronger downside protection.

It is difficult to imagine that distressed investors would take the risk of investing

down in the capital structure before they have at least a position in the senior

debt. Then, when default rates reach their highest levels they will move down

into the capital structure and they will likely look to junior securities which have

attracting valuations, resulting in a higher return potential.

Moreover, hedge funds will target companies that have the operational strength

to survive in a really tough economic environment and they are expected to

probably have an initial focus on distressed companies that are filing or have

already filed for bankruptcy or are in default and whose distressed debt will

eventually be restructured into equity.

To sum up, there are great opportunities for hedge fund managers investing in

distressed debt and experts agree on the fact that it will continue to get better in

the months and years to come.

4.2.1 European distressed debt managers

Distressed debt has without a doubt gained attention this year as the current

environment is affecting every sector. European businesses started to crack as

they were caught by liquidity needs.

In such a climate, Debtwire, the publisher of data for financial professionals in

fixed income markets, has published its annual report. The outlook is based on a

survey over hedge fund managers and reveals expectations and opinions of

managers for the European distressed debt market in 2009 and beyond.

According to hedge fund managers surveyed, high levels of debt combined with

scarce liquidity will cause an increase in insolvencies and restructurings, thus

creating opportunities for managers investing in distressed debt.

Indeed, European managers seem to agree on the fact that tightening liquidity is

the primary factor that is putting pressure on businesses. 40% of respondents

expect that cash flows are the primary factor determining the timing restructuring

proceedings. In other words, it is very likely that business will need to restructure

because they lack adequate cash flows to continue paying interests. Then over-

leverage and the inability to refinance are identified as the other two factors that

will trigger restructurings and insolvencies.

While the current economic and financial slowdown has undoubtedly triggered

opportunities to invest in distressed debt markets, many of the managers

surveyed were cautious about the effective opportunities in 2009. In particular,

the largest proportion of managers, nearly a third (27%), expects that the volume

of European financial restructurings will reach its highest level at the end of 2009

when the distressed debt market will hit the bottom. The volume of financial and

operational restructuring activities across Europe is indeed already at a very high

level. Moreover, the 21% of respondents think that there will be a decline in the

number of restructuring proceeding from the first quarter of 2010, while the 17%

forecast a decline from the second quarter.

To sum up, managers have waited throughout the last part of 2008 and the first

half of this year because they think that the last part of 2009 and the first half of

2010 will offer the best opportunities to investors in the restructuring market. At

the same time they feared and are still concerned with the high volatility and the

unpredictability of every market.

Among the people surveyed there is also the opinion that the number of

insolvencies will increase and outnumber that of restructurings. On the other

side, given the systemic risk that they create, larger businesses could face

political pressure to restructure. Moreover, high leverage will have to be

readjusted and so many businesses will have to equitise their debt and undertake

a restructuring process in order to get a better capital structure.

Respondents are uncertain about whether there will be more insolvency

situations or restructuring proceedings. Indeed, they are evenly split between the

two. The most important factors for successful restructurings are considered to be

the availability of funds and the attitude of banks.

In addition to that, managers also seek to gain control of companies with a loan

to own strategy. Investors see the chance to have their debt investment converted

to equity holdings even though they recognize that such a strategy requires time

and capital commitment.

Surveyed managers think that the most attractive investment opportunities lie in

senior debt and high yield bonds as they are believed to have the highest returns

prospects. Moreover, they also target the top of the capital structure as a

protection against the risk of depressed asset values and uncertain value

recovery.

When questioned about the most attractive sectors, the Property/Construction,

Auto/Auto parts and Consumer Retail sectors were identified by respondents as

offering the most opportunities for distressed investors in 2009. Financial,

Chemicals and Media businesses are also expected to experience problems.

Managers think that the most interesting sectors are the cyclical ones and of

course they target highly levered companies because it is harder for them to find

new sources of financing and thus are more likely to undertake a restructuring

process. Indeed, leverage multiples play a critical role in determining which

investment to undertake. Managers also recognize that it is important to

distinguish between vulnerable sectors which offer more opportunities and those

with fewer but better opportunities. That is, it is not said that the most affected

sectors are those with the best distressed debt to invest in.

4.2.2 North American distressed debt managers

Looking at the North American region, Debtwire found that the majority of asset

managers interviewed agrees on the fact that the current distressed investing

cycle will be remembered for its high level of bankruptcies across all industries

and for its unprecedented level of corporate defaults. At the same time, it will be

surely remembered for the outstanding buying opportunities that the economic

downturn is offering to distressed debt investors.

Even though the tough economic environment has caused hedge fund

redemptions to peak and has forced many funds to close, those who withstood

the storm have now the chance to soar. The consolidation of the hedge fund

industry in 2008 and 2009 has undoubtedly reduced the competition for attractive

positions and so everyone recognize the unprecedented opportunities offered by

distressed debt. Fewer hedge funds, however, will be able to capitalize on them.

It is impossible for hedge funds to predict when the distressed debt market will

bottom but for sure knowledgeable investors have the chance to post high

returns.

According to the 2009 North American Distressed Debt Outlook, investors think

that mid-2009 was the early stage of a distressed investment cycle that will

continue in 2010 and beyond.

In particular, 2008 has experienced quite low default rates despite a deteriorating

financial environment. 2009, instead, has already been full of opportunities as

companies, facing scarce liquidity in the markets, were unable to refinance their

existing debt obligations thus needing a restructuring process or being forced to

liquidation. Default rates have moved from their historical low lever in 2007 to

high levels during this year.

The 2009 initial stage has been particularly interesting also because of the strong

US government intervention which prevented many firms to fail. The

government has appeared ready to do whatever necessary to prevent a systemic

failure of the financial system and so, hedge funds investing in the area had to

keep an eye on government action as well.

Distressed investors expect that many opportunities have yet to come in 2010

when default rates will reach unprecedented levels. Indeed, next years will

represent a dynamic environment for the distressed investing community and the

majority of the managers interviewed, nearly two-thirds, anticipate that they will

increase the allocation to the distressed asset class in 2010.

Experts also foresee an increasing distressed M&A activity in North America.

Such rise in distressed M&A deals will be driven by forced consolidation and

forced sellers in the attempt to deal with the current financial climate.

Financial services sector is expected to offer the most interesting opportunities

for distressed investors. Another sector that will likely gauge the attention of

investors is the automotive manufacture sector. In fact, these two sectors are the

most beat-up of the last two years and distressed investors believe that they can

realize great value by investing in them.

However there will be significant opportunities in every other sectors that has

been impacted in 2008 and 2009, suffering the consequences of recession. It goes

without doubt that the crisis has touched almost every sector of the market so

there is everywhere the need for restructuring debt.

When questioned about where they will invest in the capital structure distressed

investors say they will commit their funds to the top of the capital structure,

because they will have collateral, covenants and more control over restructuring

processes.

Investors in the area fear that they can lose money if they start right now to invest

down the capital structure in junior debt as asset valuations could be slashed as

they were in the last part of 2008.

4.3 Default rates

As outlined before in the chapter, distressed debt investors are really concerned

with the level of default rates as the richest opportunities come just after default

rates have peaked. Such rates are thus extremely relevant for timing the strategy

in a correct manner.

Despite the turbulence in credit markets which derived from the defaults in the

US sub-prime mortgage sector, the corporate default rates were surprisingly low

in 2007, remaining somewhere near zero at the lowest historical levels.

The majority of companies were able to service their debt payments in 2007 as

economy in real terms was growing and credit conditions were still relatively

loose. Companies were able to refinance their debt and obtain longer maturities

and more favorable terms, thus being able to avoid default. Indeed, few of them

had to access the credit market in the last part of 2007 when credit conditions had

already deteriorated.

Moody’s global speculative-grade (high-yield) corporate default rate reached a

record 0.91 percent at the end of 2007, the lowest year-end level since 1981,

almost 30 years ago, when it came in at 0.70%. The rate was down

approximately 48 percent from 2006 level of 1.74 percent and since 2003 has

been well below the its last 26 years average level of 4.48 percent per year.

Chart 4.1:

Source:

In 2008, companies experienced the first consequences of tightening credit

conditions with default rates increasing sharply and approaching their average

level. The most relevant factors that are considered to have created upward

pressure on default rates in 2008 are weaker global macroeconomic conditions,

widening credit spreads and tougher corporate underwriting standards. Overall,

these events have reduced the ability of many corporates to make debt service

payments and re-finance maturing debt,

2009 has seen a surge in defaults with the global speculative grade default rate

expected to keep on increasing also in the last quarter. In particular, corporate

defaults have accelerated as access to capital for distressed companies was

extremely limited. As shown in chart 2.2, Moody’s estimates that the global high

yield default rate has sharply climbed over the year and will reach a 12.5 percent

level in December 2009. Since Moody's use a 12 month trailing default rate, this

means that they expert 12.5 percent of the global high yield market to be in

default in the year to the end of December.

It is interesting to compare such levels with the peaks that characterized 2002 and

the early 1990s. According to Moody’s the high-yield default rate in July 2009

was 11 percent and hence surpassed the peak of 10.4 percent that was registered

in 2002. Moody’s also expect that in the last quarter 2009, the default rate will go

above the 1991’s peak of 12.2 percent.

To sum up, it seems that this credit cycle will be worse than the last two in the

early 1990s and 2000s. This year is considered to be until now and expected to

be in its last part, the year with the largest number of defaults since the early

1980s.

Chart 4.2: 2009 Global High-Yield Default Rates (January – December 2009)

0.0%1.5%3.0%4.5%6.0%7.5%9.0%

10.5%12.0%13.5%

Jan

Feb Mar AprMay Ju

n Jul

Aug Sep

Ex Oct

Ex Nov

Ex Dec

Global High YieldDefault Rates

Source: Moody’s estimates

Moody’s expect that defaults will continue to increase in the first quarter of 2010

as a lot of high-yield names will need to refinance. The most affected firms will

be the cyclical businesses, the leveraged buyout during recent years and the

poorer rated ones.

The thing that catch the attention is that speculative grade default rates are

expected to go well above the previous two peaks of early 2000s and 1990s. Such

prediction will make 2010 a record year for defaults. Indeed, defaults are

expected to increase to 13.8 percent in February 2010, that is almost 14 percent

of the high yield bond issuers will have defaulted globally in the year ending in

the first quarter 2010.

After the first quarter’s peak of almost 14 percent, Moody’s forecast that defaults

will sharply decline and reach the level of 4.5 percent in August 2010. While

precisely forecasting default rates is a difficult task by nature because of the

dependency on macroeconomic and credit market conditions, which themselves

are difficult to reliably forecast, such predictions are effective in summarizing

how default rates are expected to evolve over time.

There are several reason for such a trend. The first driver underlying these

forecasts is that many of the weakest rated firms will have already defaulted,

leaving a pool of relatively stronger issuers.

Secondly, the narrowing of high yield spreads in 2009 and the fact that the high

yield bond market is re-opening will most likely allow many companies to

refinance their debt thus avoiding to go in default. Indeed, the high yield bond

spread, over government bonds yield, began increasing in the second half of

2007 and reached unprecedented levels in the fourth quarter 2008. As a

consequence, corporate defaults have peaked, or better, are just about to peak in

2009.

Instead, since the very first months of 2009 high yield bond spreads have

declined significantly even if they still remained at near-record levels. Since high

yield bond spreads have narrowed, default rates are expected to fall in 2010 after

a further increase in the first quarter.

Thirdly, many experts believe that 2010 will experience a modest economic

recovery and unemployment rates, both in US and Europe, will have reached the

highest level and so will start to decrease.

Looking at the sectors level, the Automotive industry has been the worst

performer in the U.S. during the 2009. The Media industry, particularly the

Advertising, Publishing and Printing Media sectors followed closely behind. The

European sector with the highest default rate has been the Durable Consumer

Goods sector.

Across industries over the coming year, Moody's forecast that the Consumer

Transportation sector, which largely constitute airlines, media companies and car

manufacturers, will be the most troubled in the U.S. and the Durable and Non-

Durable Consumer Goods will be the sectors most at risk of defaulting in Europe.

Another interesting index that is worth to be considered is the Moody’s

Distressed Issuer index, which measures the percentage of rated issuers that have

debt trading at distressed levels. High-yield is traditionally classed as distressed

when it trades at spreads to Treasuries greater than 1000 basis points, that is

when the credit spread exceeds 10% over government bonds.

The index began to increase at the end of 2007. It was higher than 15 percent at

the end of the second quarter 2008 and then reached almost 27 percent at the end

of the third quarter. It sharply climbed in the final three months of 2008 and rose

to a record 54.6 percent in December 2008. In 2009, especially from the second

quarter on, the index has declined standing at 28 percent at the end of September

2009. S&P has even a worse view, stating that 85 percent of all high yield

corporate bonds were distressed in January 2009. In other words, all the

theoretical definitions between high yield, stressed and distressed debt securities

were blurred in practice.

Chart 4.3 suggests that the Moody’s distressed issuer index precede subsequent

changes in the level of the high yield default rate. It is actually quite obvious that

the more distressed debt you have the larger is the number of defaults that you

will likely experience. In other words, a huge decline in loan prices anticipates an

increase in corporate defaults and this is happened especially in the current

distressed debt cycle.

Chart 4.3: Distressed Issuer Index (June 2008 – September 2009)

0%

10%

20%

30%

40%

50%

60%

Jun 0

8 Jul

Aug Sep OctNov Dec

Jan 0

9Fe

bMar Apr May Ju

n Jul

Aug Sep

Source: Moody’s estimates

REFERENCES

Ineichen A. and Silberstein K. (2008), AIMA’s Roadmap to Hedge Funds,

commissioned by AIMA’s Investor Steering Committee, The Hedge Fund

Journal, November.

Guidotti I. (2009), Trade-off between Liquidity, Size and Performance: Does

investing in liquid funds imply lower excess returns?, The Hedge Fund Journal,

March.

Klusky B. (2008), The Void in Operational Due Diligence: How to approach and

what to ask, The Hedge Fund Journal, July – Augus$t.

Bishop B., Fieldhouse S. and Jones R. (2008), Hedge Fund Replication: A

Revolution in the Making?, The Hedge Fund Journal, May.

Aziz A. (2007), The Power of Scenarios: Risk measurement and the ranking of

investment strategies, The Hedge Fund Journal, April.

Terhune H. M., (2007), Hedge Fund Management and Performance Fees,

December.

An. Fr. (2009), Hedge Fund, nel 2009 si perderanno 20mila posti, in Il Sole-24

Ore, March 10th.

Annichiarico A. (2009), Geithner: per la finanza Usa nuove regole del gioco, in

Il Sole-24 Ore, March 26th.

Brown K. C. and Reilly F. K. (2005), Investment Analysis and Portfolio

Management, International Student Edition.

Gentilini A (2009), Lipper Tass Asset Flows Report, Global Head of Hedge Fund

Research.

Christory C. (2009), A First Guess For The Hedge Fund Attrition Rate in 2008,

Olympia Capital Management Research, February.

Authers J. (2009), Hedge funds up, but all is not rosy, The Financial Time, July

19th.

Jones S. (2009), Traditional strategies boost hedge funds, The Financial Time,

August 12th.

Jones S. (2009), Hedge funds buoyant after assets surge, The Financial Time,

July 21st.

IFSL Research (2009), Hedge Funds 2009, April.

EDHEC (2009), Hedge Fund Performance in 2008, EDHEC Risk and Asset

Management Research Centre Publication, February.

Berg S. (2009), Secular Growth in Emerging Markets and How to Access It, T.

Rowe Price, July.

Paravani S. (2009), Global Investment Views - Valuations following stock market

rally are no longer compelling, HSBC Global Asset Management, August.

Avramovic A. (2009), Behind the Gates: Hedge Funds in Focus, Credit Suisse

Research, February.

Kim B. (2009), Managed Futures Investing - The Future of alternative asset

management, The Hedge Fund Journal.

Clifford C. (2009), Green shoots? Check the yield curve, CNNMoney.com, May.

Credit Suisse | Tremont Hedge Index (2009), One for the History Books: Hedge

Fund Performance in 2008, January.

Credit Suisse | Tremont Hedge Index (2009), Q1 2009 Update: Hedge Funds

Gain Traction in First Quarter, May.

Credit Suisse | Tremont Hedge Index (2009), 1H 2009 Hedge Fund Update:

Halfway There, July.

Credit Suisse | Tremont Hedge Index (2009), Convertible Arbitrage: Shifting

Gears, May.

Credit Suisse | Tremont Hedge Index (2009), Credit Suisse Liquid Alternatives

Monthly Hedge Fund Commentary, January, February, March, April, May, June,

July.

Ernst & Young (2009), Survey on risk management for asset management, June.

Spain D., Kamat A. and Knudson K. (2009), Hedge fund regulation: How should

alternative investment firms prepare for regulatory change?,

PricewaterhouseCoopers.

Garrod D. (2009), Keeping Hedge Funds in the EU – Is it UK crunch time?, The

Hedge Fund Journal.

AIMA Update (2009), The impact of the EC’s Directive on third country fund

managers, The Hedge Fund Journal.

Senate Committee on Banking, Housing & Urban Affairs (2009), Regulating

hedge funds and other private investment pools, The Hedge Fund Journal.

Cattermole C. (2009), The Evolution of Reassurance – It’s due diligence, but not

as we used to know it, The Hedge Fund Journal.

Ford D. (2009), Alternative Investment Trends – The chancing face of the

alternative investment landscape, The Hedge Fund Journal.

Kerr S. (2009), The State of Play One Year on From Lehman – Part One: supply

and demand, The Hedge Fund Journal, September.

Castle Hall Alternatives (2009), Hedge Fund Investing in a New World – Five

questions for investors and managers.

Wareham J. (2009), The Case for Managed Futures – This asset class has earned

its stripes, The Hedge Fund Journal, September.

Utah Retirement System - URS (2009), Summary of Preferred Hedge Fund

terms.

Zanchetta S. (2009), Idemagazine, September, n. 79

Consulted Websites

www.investopedia.com

www.thehedgefundjournal.com

www.thehfa.org

www.greenwichai.com

www.sec.gov

www.ft.com

www.sole24ore.com

www.bloomberg.com

www.hedgeindex.com

www.finance.yahoo.com

www.economist.com

www.hedgeweek.com